The minimum distribution rules require that participants and beneficiaries begin receiving distributions by certain deadlines and limit the period over which benefits can be paid. In this post we take a look at the RMD Rules for a Solo 401k.
Previous proposed regulations required complex calculations for determining the minimum distributions and limited the participant’s ability to change beneficiaries. The new proposed regulations simplify this process considerably and add flexibility in naming and changing beneficiaries. This newsletter examines the application of the new rules provided by the “kindler, gentler IRS.”
Background
Section 401(a)(9) was added to the Internal Revenue Code to force distributions from retirement plans so that funds are paid out (and therefore taxed) over the life of the participant or the joint lives of the participant and beneficiary. The IRS issued proposed regulations in 1987 which included a complex process of determining how much was required to be distributed annually. There were various methods of calculating life expectancy, and the minimum differed substantially depending on who was named beneficiary. Worst of all, the participant was stuck in future years with the choices he made.
On January 17, 2001, after almost 15 years, the IRS published new re-proposed regulations in response to numerous comments regarding the complexities of the existing regulations. The basic theory hasn’t changed–the IRS still wants participants to draw down tax deferred account balances while they are still around to pay taxes. However, the new rules make it easier to comply with the requirements.
Most people start tapping their retirement plans before age 70½. But participants who can get by without pulling large amounts of money from their retirement account want to take as little as possible because withdrawals are taxed as regular income in the year of withdrawal. For these participants, the use of the new rules will lighten the tax burden and leave more money in their retirement accounts to grow tax-deferred.
Effective Date
The new rules are proposed to be effective for payments made for calendar years beginning on or after January 1, 2002. For payments made for calendar year 2001, plan sponsors may apply either the new rules or the old rules. To apply the new rules to 2001 distributions, the plan sponsor must adopt an IRS model amendment.
RMD Rules for a Solo 401k
The new rules did not change when minimum required distributions must begin, referred to as the “required beginning date.” Generally, a participant must begin receiving minimum distributions by April 1 of the year following the calendar year in which the participant attains age 70½ or, if later, the year the participant terminates employment.
Employees who are more than 5% owners (and certain family members) must begin receiving distributions following age 70½ even if they have not retired. If a certain election was made in writing before January 1, 1984 (referred to as a “TEFRA 242(b) election”), benefits for 5% owners may be postponed beyond age 70½.
The year the participant reaches age 70½ or, if later, the year the participant terminates employment, is considered the first “distribution calendar year.” Normally each year’s minimum distribution must be completed by December 31. Only in the first year can the participant wait until the following April 1. If the participant waits until April 1 of the next year to take the first distribution, two years’ worth of distributions will have to be made that year.
Example 5% Owner: Bruce owns 100% of Acme Company and did not make a TEFRA 242(b) election. Born March 13, 1931, he turns 70½ on September 13, 2001. His first distribution calendar year is 2001 (the year he turned age 70½ even though he is still working), and his 2001 distribution must be made no later than April 1, 2002. His second distribution calendar year is 2002 and this distribution must be made no later than December 31, 2002.
Example Non-Owner: Sally, born May 3, 1929, retires April 4, 2001. Her first distribution calendar year is 2001 (the year she retired) and her first distribution must be made no later than April 1, 2002. Her second distribution calendar year is 2002 and this distribution must be made no later than December 31, 2002.
Defined Benefit Plans & Cash Balance Plans
Different rules apply for calculating required distributions from defined contribution plans, such as profit sharing and 401(k) plans, than for defined benefit plans. These rules generally anticipate that minimum distributions from defined contribution plans will be in the form of installment payments and that minimum distributions from defined benefit plans will be in the form of annuity payments.
Previous rules governing annuity distributions from defined benefit plans are not substantially changed by the new regulations. The IRS is still evaluating whether any changes should be made in determining whether annuity payments satisfy the minimum required distribution rules.
Solo 401 & Defined Contribution Plans
The new method of calculating required distributions is similar to the old method–the payment amount is still calculated by dividing the participant’s account balance at the end of the preceding calendar year by a life expectancy factor. What’s different is the use of a single table of life expectancy factors based solely on the participant’s current age.
The required minimum distribution is the amount the participant must withdraw each year after reaching the required beginning date. The participant can always withdraw more than the required minimum.
Many defined contribution plans are reducing payment options and moving to lump sum distributions. If the plan pays only lump sum distributions, the new regulations are likely to have very little impact on the plan.
Life Expectancy Table
Unlike prior regulations, the age of the participant’s beneficiary makes no difference in calculating required distributions. All participants now use a simplified uniform table to determine minimum distributions. The uniform table is based on the joint life expectancy of the participant and a beneficiary who is ten years younger, regardless of whether the participant has designated a beneficiary.
The only exception to using the uniform table is in the case of a participant designating his spouse as beneficiary and the spouse is more than ten years younger than the employee. In this case the IRS allows use of actual joint life expectancies of the employee and spouse. If the spouse dies before the participant, they divorce or the participant designates another beneficiary, the calculations revert back to using the uniform table.
Below is a portion of the uniform table:
| Uniform Distribution Period Table* | |||
Participant’s Age | Life Expectancy | Participant’s Age | Life Expectancy |
70 | 26.2 | 74 | 22.7 |
71 | 25.3 | 75 | 21.8 |
72 | 24.4 | 76 | 20.9 |
73 | 23.5 | 77 | 20.1 |
| *Based on the joint life expectancies of the participant and someone ten years younger. | |||
Example: Harry turns age 70½ in 2002 and his December 31, 2001 account balance is $1,000,000. His first required distribution is $38,168 ($1,000,000 ÷ 26.2).
RMD Rules for a Solo 401k: Distributions to Beneficiaries
As under the old regulations, different death benefit payment rules apply, depending on whether the participant dies before or after his required beginning date. Regardless of whether the employee’s death occurs before or after the required beginning date, the beneficiary may receive the payments over the beneficiary’s life expectancy, based on a single life expectancy table provided by the IRS.
The new rules permit the beneficiary (for life expectancy purposes) to be determined as late as the end of the calendar year following the year of the employee’s death. This delay facilitates administration of situations where one or more beneficiaries cash out benefits or give up rights to the benefit in favor of another beneficiary by making a disclaimer before December 31 of the calendar year following the year of the participant’s death.
Example: The participant designates his spouse as beneficiary and their children as contingent beneficiaries. After the participant’s death, the spouse disclaims the benefit. The eldest child’s life expectancy is used to calculate the required distributions to the children. Since the child has a longer life expectancy, the required distributions will be much lower.
Death On or After Required Beginning Date
Distributions must begin by the end of the calendar year following the calendar year of the participant’s death and distributed over the oldest designated beneficiary’s life expectancy determined as follows:
Nonspouse Beneficiary: Based on the beneficiary’s life expectancy using his age on his birthday in the calendar year following the calendar year in which the participant died, reduced by one year for each later year.
Example: Joe’s brother Fred is his beneficiary. Fred turns age 60 the year after Joe’s death. His life expectancy is 24.2 for his first distribution (based on the IRS single life expectancy table). The second year, Fred’s life expectancy factor is 23.2 (24.2 – 1).
Spouse Beneficiary: If the spouse is the sole beneficiary, based on the spouse’s life expectancy using his age on his birthday in the calendar year following the calendar year in which the participant died, redetermined each year based on the spouse’s age falling in that year.
Example: Harry’s wife Judy is his sole beneficiary. Judy turns age 60 the year after Harry’s death. Her life expectancy is 24.2 for her first distribution (based on the IRS single life expectancy tables). The second year Judy’s life expectancy is 23.3 (based on age 61 using the IRS single life expectancy table).
Death Before Required Beginning Date
If the participant dies before reaching the required beginning date, life expectancy payments for nonspouse and spouse beneficiaries as described above may be elected. The beneficiary may instead elect a five-year cash out under which the beneficiary must be paid the entire balance by the December 31 of the year containing the fifth anniversary of the participant’s death.
If the spouse is the sole beneficiary, distributions may also be postponed to December 31 of the year in which the participant would have reached age 70½.
RMD Rules for a Solo 401k: Failure to Make Distributions
If required distributions are not timely made, the participant must pay a 50% excise tax on the amount of the required distribution not made. Although the IRS does not always assess these severe penalties, plan administrators should take steps to insure that required distributions are properly made.
Conclusion
RMD rules for a solo 401k may sound difficult. For participants who do not need to live on their retirement benefits, smaller required distributions will result in lower taxes, a longer-lived tax shelter and potentially larger payouts for the participant’s beneficiaries.
