Deciding how to take minimum required distributions from IRAs and retirement plans when you reach age 70 1/2 is a difficult decision. For couples, making the wrong choice could cost the family thousands of dollars through the years. A little-known option for taking required withdrawals, commonly called the hybrid method, may be the answer to this difficult question. It helps ensure the IRA owner does not totally deplete the IRA while he's still alive, provides an income to a surviving spouse, and enables heirs to minimize income taxes due on the IRA at the second spouse's death.

By David Braze (TMF Pixy)
August 7, 2000

One of the neat things about a tax-deferred investment like an IRA is not having to pay current income taxes on any gain. Often, but not always, we may also defer the taxes due on the money we use to purchase that investment, too. To me, what I don't have to pay in income tax today is the same as receiving a no-interest loan from Uncle Sam. And, when I invest that money, it compounds untaxed as well, thus providing added leverage that enhances the growth of my retirement stash. Not surprising, then, it's often to our benefit to continue the tax deferral for as long as possible. And, through proper planning, that deferral could provide our heirs with thousands of dollars over many years -- long after we've departed this world for our ultimate retirement.

I don't know about you, but my objective is to give the tax man the least amount I can whether I'm alive or dead. Thus, I consider the issue of planning distributions from my IRAs as one of great importance. If I make a mistake here, it could cost my family some pretty big dollars. One way to make such a mistake is in the naming of beneficiaries for my IRAs (and retirement plans). Another is in choosing the method(s) I will use when taking minimum required distributions (MRD) from those vehicles when I reach age 70 1/2.

I've talked about those issues before in Have You Checked Your IRA Lately?, Designating IRA Beneficiaries -- It Does Matter, and 70 1/2: Ya Gotta Take It Sometime. Roy Lewis, our superb tax maven, wrote a great article on how to keep an IRA going for a number of years in The New S-t-r-e-t-c-h IRA and, just this week, covers inheritance issues in his article An Inherited IRA. All will further your understanding of this area.

Today, I want to re-emphasize the importance of your beneficiary designations and the results of the selection of your MRD method at age 70 1/2. In particular, I want to stress how we can protect the income of a surviving spouse while minimizing the income taxes payable by the kids on the second spouse's death.

Pretend for a moment that I've suddenly aged 40 years, so now I'm 69 instead of 29. Yeah, I know, that's a stretch of the imagination, but just humor me for a bit. If I'm 69, then next year I have to worry about MRD. That means I must make a once-in-a-lifetime, irrevocable decision as to how I'll take MRD.

According to IRS Publication 590, Individual Retirement Arrangements, I can take MRD based on a single life expectancy (mine) or the joint life expectancy of a beneficiary and me. Further, I can recalculate the single life expectancy or the joint life expectancy each year, or use a "term certain" factor that declines by one each year I take an MRD.

Guess what? While these may seem like easy decisions to make, they are actually quite complex. So much so that sometimes I'm convinced the complexity was deliberate to ensure I could leave as little as possible to my surviving family.

In making my MRD decision, my concerns are threefold:

1. I want to ensure I don't run out of money before I die;
2. I want to protect Mrs. Pixy's income in case I predecease her;
3. I want to give the kids the widest possible latitude in how they will take distributions and pay income taxes on any IRAs they inherit.

Using the recalculation method with Mrs. Pixy as my joint beneficiary ensures the IRA will last as long as I do. When I die, she may take over the IRA as her own, so her income stream will be protected. Further, she may name a new beneficiary or two, and thus provide for a stretch IRA, which meets my third goal. Sounds like the best of all worlds, right? Well, maybe, but only provided Mrs. Pixy isn't so rude as to leave this world before I do.

Suppose Mrs. Pixy is inconsiderate enough to do that. What happens? Well, I have to keep on using the recalculation method for my MRD. I can name a new beneficiary for the IRA, but I cannot use that beneficiary's life expectancy in my calculations. Therefore, when I die, there is no life expectancy to use. And that means, regardless of what my kids want, the balance of that IRA must be disbursed -- and taxed at the ordinary rates of my heirs -- no later than December 31 of the year following the year I die. Bummer. That's not what I would want. I want the kids to be able to take distributions over the longest possible period, and ideally over their lifespans should they so desire.

OK, let's try another route then. This time I'll use a term certain method with Mrs. Pixy as my joint beneficiary. Based on my age of 70 and hers of 67, the IRA must be drawn down over a period of 22 years. It's possible, then, for me to outlive my IRA -- something I may not want. If I die before the 22 years passes, Mrs. Pixy may still take over the IRA as her own and name new beneficiaries, so her income and the kids are protected the way I wish. If she dies before I do, I can still take the money over what's left of the 22-year MRD period. And, if I die after she does, then the kids may take the proceeds over whatever number of years is left of those 22 years. All in all, that's not a bad result, but it still doesn't give the kids the full benefit of a stretch IRA.

There may just be a better way to do all this, folks. What IRS Publication 590, Individual Retirement Arrangements doesn't really tell us is that when I use Mrs. Pixy as my joint beneficiary, I don't have to choose just a recalculation or a term certain method for both of us. No, indeed I don't. There's a little-known proviso that will permit me to use the recalculation (or term certain) method for my life, and the term certain (or recalculation) method on her life. This hybrid method, if permitted by my IRA provider, may give me a much better result. After all, I don't know who will die first, Mrs. Pixy or me. In my case, it's probably better to use the recalculation method on my life, and the term certain on hers.

The hybrid method allows us to avoid outliving the money in my IRA. If I die first, then Mrs. Pixy can take over the IRA for herself and create a stretch IRA for the kids. If she predeceases me and then I die two days later, the kids may take what's left in the IRA over the period left in her term certain life expectancy factor at that time. That's not a perfect solution, maybe, but at the time MRD must start, she's expected to live more than 18 more years, or until age 85. So, assuming she died at age 75 and I followed her soon after, the kids could still spread the IRA distributions over another 10 years rather than having to take the money and pay income taxes in one year. That's sure to be a longer period than had I used a term certain method for my life expectancy. All in all, the hybrid method appears to give me the greatest chance of meeting all three of my goals.

There are a few hurdles to overcome before I can use it, though. To use the hybrid method, my IRA provider must agree to allow it. (Note: You should check to make sure yours does.) I must notify that provider in writing that I will use that method before MRD must start. And, I must have a table computed showing what fraction of the IRA I must take as an MRD each year.

Of those three requirements, perhaps the toughest is determining the table I must use. That table will be unique to my spouse and me, and yours will be unique to you and your spouse. Due to the complexity of the actuarial computations involved, let alone the difficulty we may encounter in interpreting the applicable IRS regulation, this probably isn't a do-it-yourself project. Almost all of us will want to use the services of a tax expert familiar with the hybrid method of taking MRD to develop the withdrawal schedule for us. Hey, there are times when it just makes good sense to hire a pro, and to me this is one of them.

So much for the problems of taking MRD. I tend to like the hybrid method. Still, it's not an easy decision for any of us. Yet we can't ignore it, because if we do, Uncle Sammy will be there in a flash to scarf up family funds we really didn't have to let him grab. Think it over, and make your choice. Just be sure you do so before MRD must begin, though, or it will be too late.

See you next week. As always, let's hear your comments on the Retired Fools board.

Best to all... Pixy