Taxpayer Relief Act will affect retirement

Issue: June 1, 2001

ByFred L. Dowd

President Bill Clinton signed the Taxpayer Relief Act of 1997 into law on August 5, 2000. Details of this tax legislation are not final, but some of the key provisions as they apply to IRAs and qualified plans are noted here.

Key provisions

The threshold limits for determining tax-deductible IRA contributions will be increased for IRA account holders and spouses who are active participants in employer-sponsored plans. The threshold amount for a full deduction will increase gradually for single filers from $25,000 to $50,000 by year 2005. The threshold amount for a full deduction will increase gradually for joint filers from $40,000 to $80,000 by year 2007.

Roth IRAs have been created. While any contributions to these new Roth IRAs are not deductible, distributions are tax-free if those contributions are held in the IRA for at least 5 years and the distribution is made upon attainment of age 59½ or due to death or disability. First-time homebuyers can tap these IRAs for help with the purchase of their home. Eligibility for Roth IRAs will be phased out between $95,000 and $110,000 for single filers or between $150,000 and $160,000 for joint filers. Contributions to both regular IRAs and Roth IRAs are aggregated. The total contribution cannot exceed $2,000.

Family members are able to make nondeductible contributions of $500 per child per year into Education IRAs. Earnings will accumulate tax-free. Distributions for qualified educational expenses will also be tax-free. However, certain income and other restrictions may apply.

Penalty-free withdrawal from both regular and Roth IRA accounts will be allowed up to $10,000 for first-time home buyers.

Penalty-free withdrawals from IRA accounts will be allowed for certain qualified educational expenses.

The 15% excise tax on excess distributions and the 15% estate tax on excess accumulations have been repealed.

Matching contributions will not be considered as elective deferrals for self-employed persons. This clarifies that those self-employed persons sponsoring Simple Plans may contribute up to $12,000 for themselves.

The automatic cash out-of-plan benefits (plan distributions not requiring spousal consent) has been increased from $3,500 to $5,000 for plan years beginning after the enactment.

Required Minimum Distribution

Changes in the rules for Required Minimum Distribution (RMD) from IRA accounts has proven beneficial for many IRA account holders. Rules for making withdrawals from these accounts have been made easier. It is a boon for those account holders wishing to use a trust or other entity as beneficiary for these assets.

According to the old rules, at age 70½ the retiree’s withdrawal schedule became fixed. This schedule was based upon two life expectancies — that of the retiree and that of his/her spouse or beneficiary. Once the schedule for withdrawal was determined, the IRA owner was locked into that schedule. Even if he changed beneficiary at a later date, his schedule for withdrawal of funds could not be reduced. Distributions from an IRA ac count are taxed at ordinary income rates.

The new regulations make this withdrawal process much simpler. They also afford more financial security to the recipient because the slowest withdrawal rate, formerly available to only some participants, is now standard for everyone.

Estate planning

An added benefit is better estate planning. Under the old rules, it was beneficial for the IRA owner to have as his/her beneficiary a spouse or other person in order to use the two-life tables rather than a single life to determine minimum required distribution. Under the new rules where everyone can use their life expectancy plus a second hypothetical beneficiary ten years younger, it is not imperative to have another person as beneficiary. Now it may be feasible to use a trust or other entity.

This change in determining the required minimum distribution using the life expectancy of the IRA owner plus a second hypothetical beneficiary 10 years younger allows those participants with a spouse less than ten years younger to take much less in required distributions annually. More money can be left in the IRA to grow tax-free. Under the new rules, a 70-year-old participant is required to take only 3.8% of the value of the IRA.

There is an exception to this new process of determining RMD. If your spouse is more than 10 years younger than you are, you may use that spouse’s actual birth date to determine the minimum required distribution, thus making those distributions even lower.

The greatest benefit I see for my clients in regard to this IRA change is that they no longer have to choose a beneficiary simply to keep the RMD as low as possible. The beneficiary choice for your IRA will now have no effect on the required minimum distributions, so you can plan your beneficiaries according to your wishes.

This new change also allows the participant to plan after death. You are still required to name potential beneficiaries during your lifetime, but the final beneficiaries need not be named until one year after your demise. This allows for wealthy family members to disclaim their share of the money in favor of other family members more in need of financial help. It allows for a wealthy widow with other means of income to disclaim her husband’s IRA, allowing the IRA to roll directly to children.

Any changes in estate planning or changes of beneficiary for qualified plans and IRA accounts must be discussed with a qualified tax attorney. There are certain rules that apply in order for a trust or other entity to qualify as the plan beneficiary.

A note from the editors:

As this issue was going to press, the House of Representatives passed the Retirement Savings Bill. One key provision is an increase in the maximum annual contribution to IRAs from $2,000 to $5,000. The bill now moves on to the Senate.

For Your Information:

Fred L. Dowd is a registered investment adviser and portfolio strategist with physician clients throughout the United States with offices at 104 S. Wolcott St., Ste. 740, Casper, WY 82601. He can be reached at (800) 252-3693; fax: (307) 234-3557; e-mail: fldowd@fldowd.com; Web site: www.fldowd.com.