Yesterday, President Bush signed into law H.R. 7327, the Worker, Retiree, and Employer Recovery Act of 2008 (WRERA), which included certain provisions designed to suspend so-called Required Minimum Distributions (RMDs) for the upcoming 2009 tax year. But will that really do much to help our clients? Probably not in most cases.
Under the new IRC Section 401(a)(9)(H), created under WRERA, the RMD requirements will not apply for the 2009 calendar year. As a result, if you otherwise needed to take an RMD for 2009, either as a living owner of a retirement account who has reached the Required Beginning Date, or as the beneficiary of an inherited retirement account, you will not need to take your RMD for 2009. Note that if you reached age 70 1/2 in 2008, which means your first RMD is due by April 1, 2009, you must still take THAT RMD by April 1. It is the RMD that is due FOR the 2009 tax year that is waived. On the other hand, if you turn age 70 1/2 in 2009, such that your first RMD would be due by April 1, 2010, the RMD will still be waived, because it is FOR the 2009 tax year. For those who have long since reached their Required Beginning Date and take ongoing RMDs, the provisions simply suspend the requirement to take an RMD in 2009. RMDs will be required again after 2009. These rules apply for IRAs, as well as other types of defined contribution employer retirement plans (e.g., 401(k) plans, profit-sharing plans, etc.), but not pension plans which must still continue payments.
An ancillary effect of the RMD suspension rule is that if the beneficiary of an inherited retirement account is subject to the 5-year rule, then the 2009 tax year will be ignored for the purpose of calculating the 5 years. For example, if a retirement account owner died before his/her required beginning date in 2007, the 5-year rule would require the account to be fully liquidated by December 31, 2012. Now the beneficiary will have until December 31, 2013, because the 2009 tax year will not count as one of the 5 years. However, it's worth noting that other time deadlines - such as the requirement to split beneficiary IRAs by December 31st, 2009 for a decedent who passed away in 2008 - ostensibly still apply, even though the RMD withdrawal requirement itself has been waived. There will almost certainly be additional clarification from the IRS and Treasury about how to cross-apply some of these other requirements in light of the RMD waiver.
Overall, these seem like some nice "relief" provisions, but how much do they really accomplish? The original context of the "suspend RMDs" discussion was about relief for the current 2008 tax year, where retirees complained that their RMDs were calculated using the 12/31/2007 account balance, and due to market declines the withdrawal seemed "excessive" relative to the current account balance after the decline. RMD relief was called for to keep seniors from being forced to: 1) take withdrawals and incur "unnecessary" income taxes; and, 2) sell out during a market decline.
Of course, the reality is that #2 is actually irrelevant. An RMD does not force a client to change investment positions. It merely forces the client to move the value of that position from a retirement account to a taxable account. For those who hold their investments in a brokerage account, this can typically be accomplished by simply submitting a request to journal the funds from the retirement account to a taxable account, in-kind. No selling is necessary. If the funds are coming out of an employer retirement plan, an in-kind transfer is not possible, but most clients would only be out of their investments for a matter of a few days or a week or two from the date of distribution until the date the money could be reinvested. Ostensibly this might disrupt the investment continuity slightly, but to say the least there was nothing about an RMD that would force the client to cease holding the investment position with the hopes of a rebound.
On the other hand, the tax impact is more real, but it is still inaccurate to suggest that the taxes were unnecessary or otherwise avoidable. Taking a withdrawal from a retirement account - by choice or by force of the RMD rules - will always incur a tax impact, because the retirement account is pre-tax. Consequently, the client would NEVER had been able to spend any of the retirement account funds without incurring a tax liability! The only benefit to a client of avoiding an RMD is the opportunity to DEFER the time until the withdrawal must occur and be taxed. In other words, the retiree can defer and pay tax later when he/she is ready to take the withdrawal for spending, instead of now when it might be "required" under the RMD rules.
So what is the value of this deferral? Well, let's assume we have a 75 year old client (RMD factor of 22.9), whose account balance was $200,000 at the beginning of the year but is now down an aggregate of 30% across its diversified stock/bond mix. The RMD would be $8,733, which is about 4.37% of the original account balance, but 6.24% of the reduced account balance. If the client is subject to a 25% tax rate, the taxes due would be $2,183. Of course, the client was always going to pay that $2,183 someday (wherever the client wanted to try to spend the money), so the client really just enjoys the opportunity to earn 8%/year growth on the $2,183 for some extra time. This means the economic value is about $175/year of tax deferral, on a current account balance of $140,000. This means the economic value of the retirement account is enhanced by a mere 12.5 basis points per year - an extra $175/year on $140,000!
Of course, the RMD relief didn't get enacted for 2008. It was enacted for 2009. In 2009, the client's RMD will now be calculated on the reduced $140,000 account balance, so the "mismatch" of a current RMD based on a much higher prior year balance is a moot point. The RMD factor will change to 22.0, because the client is one year older. In the upcoming 2009 tax year, the RMD would have been $6,364. At the same 25% tax rate, this would be a tax liability of $1,591, and at an 8% growth rate the economic value is only $127. This is an economic value of 9.1 basis points per year - a further reduction of economic value by implementing the rule for 2009 and not 2008. And the client will not enjoy the full 9.1 basis points each year after 2009, either - because future RMDs will apply (based on the higher account balance since there was no 2009 RMD), which will force a portion of the deferred taxes to be paid each year anyway.
In the end, the economic value of this "relief" provision seems somewhat limited. It may have been slightly more helpful if it was enacted for 2008, but unfortunately the administrative and other complications of a quick year-end enactment meant 2008 relief just wasn't feasible. In terms of the 2009 relief itself, sadly many clients could recover a similar or greater economic value simply by taking more time to analyze the costs of the investments they own, to take other basic tax planning steps, to review their budget and trim $3/week of expenses, or any number of other options. Furthermore, there is actually NO economic value to any client who actually uses a retirement account to fund retirement expenses. For such clients, withdrawals will still occur from the retirement account, simply because it's needed for current cash flow. Thus, somewhat ironically since this is a "relief" provision, the RMD waiver actually only creates economic value for those who have sufficient wealth to be able to avoid withdrawals from retirement accounts anyway (either due to the availability of either other assets or other income sources such as Social Security, pensions, etc.), and not for those who are actually in greatest danger of depleting their reduced retirement account balances.
Will some wealthier clients be happy to be able to avoid sizable RMDs? Almost certainly - tax deferral is still tax deferral, the dollar amount of the economic value increases with account size (9.1 basis points on $200,000 isn't as much as 9.1 basis points on $1,000,000!), and any value is better than not having it. But for clients who believe this is a great boon for them, the sad news is that it's probably not. And if the losses have been so severe that the client actually NEEDS the retirement account funds... then unfortunately, they will probably enjoy no value at all from the 2009 RMD relief provisions!