Benefits held in qualified plans. IRAs, and 403(b) annuities (generally referred to as tax-favored retirement programs) are among the assets least understood by financial and estate planners. Yet for man individuals, these programs constitute a significant part of their estates, and an understanding of the rules that apply is essential to proper financial and estate planning. Planning for these assets, known as distribution planning or "intergenerational minimum distribution planning,"* can be one of the most important elements in the financial and estate plan of such individuals.
THE RULES OF DISTRIBUTION PLANNING
IRC Sec. 401(a) sets forth the rules that apply to distributions from all tax-favored retirement programs. These rules have been explained in great detail in temporary regulations issued by the IRS in 1987 and are as follows:
Mandatory Distributions. No distribution need be made from a tax-favored retirement program prior to the year the individual reaches age 70-1/2.
Voluntary Distributions. Amounts can be withdrawn at any time from an IRA, subject to an income tax and, in some cases, penalty taxes. Withdrawals can be made from a qualified plan only in accordance with the terms of the plan. The IRS prohibits a pension plan, whether defined benefit, money purchase, target benefit, or a cash-balance type, from permitting distributions prior to the date a participant terminates employment or attains his or her normal retirement age. A profit sharing plan is permitted to allow distributions not only at termination of I employment or attainment of the plan's normal retirement age, but also of amounts held in the plan for at least two years, and of all amounts held for a participant who has completed five years of service, but such distributions can only be made if the plan specifically allows them. In all plans, distributions can be made when the plan terminates.
Mandatory Distribution Amounts. When distributions must begin (generally as of the year the individual reaches age 70, the amounts must be withdrawn over a period no longer than the joint lives or life expectancies of the participant and his or her designated beneficiary. To the extent the minimum amount is not withdrawn, the plan participant or account holder is subject to a 50% excise tax.
Distributions from defined benefit plans, if payable in the form of an annuity, must be made in periodic installments at least once a year. For this reason, distribution planning is much more restricted when an annuity structure is used. With the exception of certain cost-of-living adjustments and other minor adjustments in payments, the annuity form does not allow an meaningful flexibility from year to year in the amount to be distributed.
Distributions from any qualified pension or profit sharing plan, including a defined benefit plan, and from an IRA, can be based on an account balance approach. Such a distribution method from a defined benefit plan must be specifically permitted by the terms of the plan. The account balance approach involves dividing a number based on life expectancy into the account balance to develop the minimum required distribution.
The life expectancy measuring period cannot exceed the joint life expectant of the plan participant and the designated beneficiary. The law permits the life expectancy of the plan participant or account holder to be recalculated annually, as an alternative to freezing the life expectancy at the time the measuring period is fixed. If the spouse is the beneficiary, the life expectancy of the spouse can also be recalculated in determining the minimum distribution. The regulations require the use of annual recalculation unless the participant elects against recalculation. The election is only permitted if the plan or IRA allows the election to be made, or mandates that annual recalculation does not apply.
Planning for Death Benefits--Spouse Beneficiary. …