You asked for background information on new federal regulations on minimum required distributions from traditional Individual Retirement Accounts (IRAs) in order to reply to a constituent's letter asking several questions about the change.

SUMMARY

In 2001, the Internal Revenue Service (IRS) revised its rules for calculating the minimum annual distributions owners of traditional IRAs must take from those accounts after they turn age 70½. The new rules, which took effect for distributions on and after January 1, 2002, simplified the method of calculating minimum required distributions (MRD) and, as a result, allowed most IRA owners to shelter more income from taxes for longer periods. The IRS rules set a minimum distribution, not a maximum. Anyone who needs more income from his IRA is free to take out more.

Your constituent complains that the change operated unfairly in his case by reducing his monthly income from his IRA. But it appears that this result stems only indirectly from the MRD change. Although he does not say so explicitly, it appears that your constituent rolled his IRA into an annuity that links his monthly payments to the MRD for traditional IRAs. Because he is receiving payments through an annuity, his annuity contract allows him to increase them above the IRS-specified minimum level only by paying "surrender charges. " Annuity companies commonly impose such charges when an annuitant seeks to change or be released from the annuity contract.

Furthermore, IRS rules governing IRA payments under annuities have not changed. This may be why your constituent, upon questioning his financial advisor, was offered an alternative method of calculating his distributions for 2002 that almost equals his 2001 distributions.

This report provides background information on minimum distribution requirements and the new IRS rules and attempts to relate them to your constituent's situation as described in his letter. We also enclose an excerpt from IRS Publication 590 that describes the rules for IRA minimum required distributions in greater detail.

As you know, the General Assembly has no jurisdiction over the law or regulations governing IRAs, the Internal Revenue Service, or federal taxation.

"TRADITIONAL" IRA

Federal law allows qualifying individuals to deposit a maximum amount (generally, $ 3,000 per year as of January 1, 2002) of their pre-tax income into an IRA each year. Income taxes on both the deposits themselves and on interest or other earnings that accumulate in the account are deferred until the money is withdrawn. IRAs like this are called "traditional IRAs" to distinguish them from Roth IRAs, which have different characteristics. The new MRD rules apply only to traditional IRAs.

MINIMUM REQUIRED DISTRIBUTIONS FOR TRADITIONAL IRAS

Because the money in a traditional IRA account is not taxed until it is withdrawn, funds cannot be held in the account indefinitely. The tax law requires the account owner to start withdrawing money from the account by April 1 of the year following the year he turns age 70½. He may withdraw the entire balance at once or in periodic payments. He can choose the size of the periodic payments but he must withdraw at least a minimum amount every year. If he does not, he must pay a 50% excise tax on the difference between what he actually withdrew and the minimum.

The minimum amount an account owner must withdraw (and pay income taxes on) each year is called the minimum required distribution (MRD). In general, the IRS requires account owners to calculate their MRD by dividing the account balance as of December 31 of the year before the distribution by a life expectancy factor based on the owner's and any account beneficiary's ages. This life expectancy factor is called a "divisor. " It is this life expectancy factor that the IRS adjusted as of January 1, 2002 and that may have indirectly affected your constituent.

IRS regulations in effect between 1987 and 2001 required each individual's MRD to be calculated using a divisor that varied depending on whether or not the account owner had designated a beneficiary and what method he elected to use to determine his own life expectancy and (if applicable) that of his spouse. According to one commentator, "There were four possible computation methods just for a participant whose beneficiary was his spouse, plus two possible tables to be used for non-spouse beneficiaries and one last table to be used if the participant had no designated beneficiary. " ("Understanding the New Minimum Distribution Rules," Natalie B. Choate, Esq. , Bingham and Dana LLP, Boston, Mass. )

In January 2001, the IRS proposed new rules that greatly simplified the MRD calculation by establishing a uniform life expectancy table for most participants. The uniform table uses divisors based on the joint life expectancy of an account owner aged 70 or older and a beneficiary 10 years younger (see attached copy). This results in larger divisors and smaller MRDs. The new rules not only simplify the MRD calculation, they also allow the vast majority of account owners to shelter more income from taxes for a longer period of time, if they take only the minimum distributions.

The new MRD is effective for distributions for calendar years beginning on or after January 1, 2002. IRA owners could choose whether to use the new or the old MRD for distributions in calendar 2001.

YOUR CONSTITUENT'S SITUATION

Although he does not say so explicitly, it appears from your constituent's letter that he rolled his IRA over into an annuity. His mention of dealings with New York Life and, particularly, his mention of "surrender charges" lead us to this conclusion. Annuities are contracts with a financial services company (often an insurance company) under which the annuitant deposits money with the company and the company agrees to provide fixed monthly payments to the annuitant for a specific term of years. If an annuitant wants to change the terms of the contract or get out of it completely, the company usually requires him to pay "surrender charges. " These charges commonly decrease over the annuity's term.

Your constituent does not provide any details about his annuity contract, but it appears that the monthly payments under his contract are linked to the MRD for traditional IRAs. When the new IRS rules on calculating MRDs led to lower minimums, your constituent's monthly annuity payment was reduced. And even though there is nothing in the IRS rules that prevents a person from taking more than the minimum, if your constituent does so, New York Life will impose surrender charges under his annuity contract.

The new MRD rules described in this report apply only to payments from traditional IRA accounts not made under an annuity contract. The IRS did not make any changes in "the basic structure" of its rules on annuity payments. This may explain your constituent's eligibility for an alternative calculation using a 10-year "single life" expectancy that, he acknowledges, restores his 2002 monthly payment to within $ 10 of his 2001 level. Under the new MRD uniform table, no such option is available.

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