WATCH OUT FOR FIVE-YEAR IRA RULE

Rules governing individual retirement accounts are a nightmare, and the five-year rule is one of the worst parts of the nightmare. Here are the basics of the five-year IRA rule and how to avoid costly mistakes.

The five-year rule is a requirement that an IRA's assets must be distributed to the beneficiary by December 31 of the fifth year following the owner's death. So if the owner dies January 1, 2001, the assets would have to be distributed no later than December 31, 2006. But exactly how and when the five-year rule applies depends on when the IRA owner dies and who is the designated beneficiary, if one is named.

Let's start with the most common situation: the spouse of the IRA owner is the beneficiary. Let's also assume the owner dies before he or she is required to start taking minimum IRA distributions, which is April 1 of the year following the year the owner turns 70 1/2. In this situation, the surviving spouse has three choices. One is to roll over the account into his or her name and take distributions based on the survivor's life expectancy (or combined with a newly named beneficiary). The survivor also could choose to leave the IRA in the decedent's name and start withdrawals by December 31 of the year the deceased would have turned 70 1/2. Or the survivor could empty the account within the five-year rule. But there is no real benefit to choosing the five-year option because you lose the tax deferral growth inside the IRA as well as kick up a big tax bill in the year of withdrawal.

One word of caution, however. While federal law doesn't require the spouse to choose the five-year rule, the financial institution serving as custodian of the IRA may require a five-year payout. In that event, the owner should consider moving the IRA to another custodian, or the beneficiary can move the IRA after the owner dies.

In the event the owner dies after required distributions have begun, the spouse or nonspouse may have some distribution options, but the five-year rule does not apply. (Just be sure to check that the custodian doesn't have a five-year rule.)

What happens if the IRA owner names a person other than a spouse as beneficiary? This is where the rule gets more complicated, and costly mistakes often are made. Again, assuming the IRA owner had not started required distributions, the nonspousal beneficiary has three choices. One is to follow the five-year rule, but again, there is a loss of tax deferral and a big tax bill, especially if you wait until the fifth year to take out everything. A second option is to empty the account by December 31 of the year following the death.

The third option is the life expectancy rule. This means the beneficiary chooses to take minimum distributions based on the beneficiary's life expectancy. If the beneficiary is significantly younger than the owner, say a young adult, the tax benefits of this deferral can be tremendous, allowing the IRA to grow substantially in size.

The key here is that the beneficiary must choose the life expectancy option no later than December 31 of the year following the owner's death, which is when the first required distribution must be made. If the beneficiary doesn't choose that option by then, the five-year rule automatically goes into effect.

Some beneficiaries who feel they want or need the money within five years may ignore the life expectancy choice. However, it still makes sense to take that option. You may find that circumstances change, and you don't need or want the money, and then you can let it grow. If you do still need the money within five years, you can take it out of the IRA at any time anyway, even if you've made the life expectancy choice.

As in the case of the spouse as beneficiary, if required distributions have already begun before the owner dies, the five-year rule doesn't apply.

What happens if no one is named as beneficiary, or the estate, a charity or trust is named? Assuming distributions have not begun, the five-year rule applies automatically in the case of no beneficiary named, or the estate or a charity is named. A trust as beneficiary may avoid the five-year rule as long as several trust requirements are met.