Posted by Ed Slott, CPA
http://www.irahelp.com
January 31, 2003
From: Ed Slott © 2003
Author of:
The Retirement Savings Time Bomb… and How to Defuse It (Viking, 2003)
www.irahelp.com
President Bush Proposes Sweeping Changes in Retirement Accounts
Released by the Treasury Department on January 31, 2003
Is this the end of IRAs? Or the beginning of a new era of tax free retirement income?
Maybe both. At least it looks that way, if these proposals become law. New retirement and lifetime savings accounts will be created providing tax-free income for almost everyone.
But the biggest question of course will be which Senator will these new accounts be named after? I’m guessing it won’t be a Democrat.
The second biggest question I’m getting is "Ed, will this put you and your IRA guru buddies out of business?" The short answer is of course "No." Like all new tax legislation, this will all have to be explained in English so that taxpayers can take full advantage of the new retirement accounts. I expect this transition to take several years before it all sinks in and all the bugs and conflicting tax provisions are worked out. After that, we might indeed have simplification and I’m all for that regardless of the affect on my business. I was a pretty darn good bus boy once. I also sing and play guitar.
However, and this is a big however, the fact that this will "simplify" the tax code is deceptive. I can already see the big tax publishing companies licking their chops over this. My newsletter, Ed Slott’s IRA Advisor will probably get at least another five year run out of this. Heck, I’m still explaining the Roth rules to readers and that started in 1998.
I base this on all the times in the past that the tax writers, the President or any member of Congress used the word "simplify." That single word has exponentially increased the business and incomes of accountants, tax attorneys and financial planners every time it was used. The word "simplify" is like having a winning lottery ticket for tax advisors. Just look at the 1986 tax act (TRA), which later became known as (ARA) the Accountants Retirement Act, because of all the new business that was generated explaining the tax simplification provisions of that Act!
If all of this passes or even some of it makes it into law (and it does seem likely), then there will be all sorts of transition rules, grandfather rules, distribution rules for the new accounts and estate planning opportunities to explore with these new tax free retirement accounts. With all the expected buildup, it is likely that much of this wealth will not be spent during the account owner’s lifetime and that will present new estate planning options on how to deal with these accounts when they are inherited.
Lawyers will see increased use of trusts due to the expected large amounts of tax-free funds being left to beneficiaries. Leaving these accounts to trusts will be so much better than leaving a traditional IRA to a trust because of the income tax on accumulations in trusts. Traditional IRAs are subject to income tax on withdrawal, but these new retirement accounts are not. There will be no trust tax problems as there are now. Trusts are taxed at the highest income tax rates of all and in the past that was a problem for traditional IRAs left to trusts. That problem will now be removed opening up a whole new era of creative estate planning for these tax-free accounts that will be able to be paid to trusts with no income tax exposure. Attorneys will not be able to handle all the business that will come their way.
Financial planners will have a field day with this if they can encourage clients to invest in these accounts. For wealthier clients, planners could help them convert their taxable funds to tax free accounts. There is no income limit for conversions and no limit on the amount that can be converted for example from an existing IRA to a new Retirement Savings Account (RSA). Over time, planners will have more money under management and will earn more, even though there is an up front cost to converting.
Some have already said this could hurt annuity sales for planners. I disagree. I have annuities in my own IRA. The key to the annuity for myself and many other annuity owners is not the tax deferral. If that was the only reason to purchase an annuity then I agree that you don’t need a second layer of tax deferral. Like many others, I bought the annuity for the guaranteed death benefit and the guaranteed steam of lifetime income. In these volatile times, I believe there is a place for these annuities inside these new retirement accounts. It’s an insurance policy for your IRA, LSA or RSA. Of course there are fees. That’s what you pay if you want these benefits not found in traditional mutual fund investments.
It’s true that some rules will be simplified, but many others will be created and then all the open questions will have to be resolved when IRS writes up another chapter of income tax regulations. Then, whatever is still unanswered will be the subject of future IRS Private Letter Rulings and Revenue Rulings, and technical corrections to the tax law.
Even though no further contributions can be made to IRAs after 2003, there will be many, especially in this economy, who simply cannot afford to convert their existing traditional IRAs to the new Retirement Savings Accounts so they will have to maintain their existing traditional IRAs and still follow all the distribution rules that apply. In addition, future contributions can only be made to LSAs or RSAs (except for rollovers from plans which can continue to be made to traditional IRA rollover accounts), so those who do not convert will have to keep both types of accounts. I have already asked several people if they would convert and most of them said they could not afford to right now, but might in the future. They will have to keep both the old and new accounts active adding more, not less tax complications to the mix. If traditional IRAs are converted and include nondeductible contributions, those would have to be accounted for under the pro-rata rule similar to the way they would have to account if they converted such an IRA to a Roth. The IRS might use an expanded Form 8606 or create a new form to record the conversions of traditional IRAs to the new Retirement Savings Accounts (RSAs).
One thing is sure. There will be a ton of confusion, not only by taxpayers who want to take advantage of this, but also by financial advisors who must learn all this rather quickly. In addition, the banks, brokers, mutual funds companies must quickly educate all employees who will be swamped with questions from their customers. Given all the layoffs in these institutions, will they have the personnel to timely educate all their customers? Probably not. The result for the first or second year will be mass confusion and errors, and IRS will most likely be asked to step in and excuse many of these mistakes, as they did when Roth IRAs became available. In fact, this year is the sixth year for Roth IRAs and there is still confusion on how the Roth IRA withdrawal and eligibility rules work, and that was also thought to be simple.
Employers, particularly the self-employed, may no longer offer retirement accounts to workers since workers can contribute so much more to their own Lifetime Savings Accounts (LSAs) or Retirement Savings Accounts (RSAs) under the proposal. If employers do move away from plans, employees would lose the matching contributions that were made to their 401(k). That was free money. However, if they wanted, employers could bonus their employees the money to contribute to the employees’ own LSA or RSA. This way the employer receives a tax deduction for the extra payroll and does not have to bother maintaining a plan.
These will be interesting times, but there is no question that these proposals will benefit those who can afford to take advantage of the new opportunities. The current contribution limits are not keeping the majority of workers from contributing more to their retirement accounts. Right now most people don’t fully fund the $3,000 annual IRA contribution, so raising it to $7,500 or $15,000 will not have an impact if you do not have the funds to invest. So the new higher contribution limits may not increase the amount people save for retirement. Since this is after-tax money that is being contributed, you might have to earn $20,000 before you can net the $15,000 to sock away each year, assuming you don’t plan on eating.
The bottom line is that these proposals will allow anyone who has the cash to greatly expand the amounts that they can contribute to tax free accounts. But if you cannot afford it, then it won’t be much help to you. However, it would provide an incentive to be more disciplined and save more and that is good. Effectively under this plan, most people could transfer most of their savings over time to tax free accounts. From then on, all of your savings will be sheltered from income taxes.
Our current tax system penalizes savers, through estate tax and income tax on already taxed money. This new system would be the first step towards a tax structure that actually rewards savers. That is the most positive aspect of the plan and that is why I support it. My only reservation with the plan is for those who still want tax deductions for current IRA contributions. Although, I have always said that you are better off not taking the up front tax deduction in exchange for a lifetime of tax-free compounding, there are still some who need cash now and count on that deduction to be able to make their IRA contribution. The President’s plan eliminates contributions and tax deductions for traditional IRAs after 2003. I think that these accounts should be retained for the benefit of those who want to contribute to a traditional IRA and want the up front tax deduction. For many, the tax deduction is the only reason they contribute to an IRA. They will have to change the way they look at saving for retirement, but they will be better off in the long run by being able to withdraw tax-free forever.
This plan also beats the heck out of the tax-free dividend proposal, which alienated many IRA owners who would receive no benefit of the tax-free dividends in their retirement accounts. In contrast, this plan rewards those who save for retirement.
For myself, I will take full advantage of this. I would convert my IRAs to RSAs (I could not do that before due to the $100,000 Roth conversion eligibility limit). I would contribute the $30,000 annually to my and my wife’s LSAs and RSAs ($15,000 each). In the long run, under this plan I would move most of my taxable funds to tax free accounts. Then I would live on tax-free money in retirement and leave what’s left to my children, and that money will also be income tax free to them. Sounds like a plan.
Ed Slott © 2003
Author of:
The Retirement Savings Time Bomb …and How to Defuse It (Viking; 2003)
www.irahelp.com
Here are new retirement plan proposals:
Assuming that President Bush gets everything he wants, (like my kids) here is what we will have beginning this year:
Two new types of individual retirement savings accounts will be created:
1.Lifetime Savings Accounts (LSAs)
2.Retirement Savings Accounts (RSAs)
The general idea here is that we will be able to consolidate all our IRAs into these two accounts and simplify the paperwork.
One new universal retirement plan for businesses:
Employer Retirement Savings Accounts (ERSAs)
How the New Accounts Will Work
Lifetime Savings Accounts (LSAs)
Anyone can contribute up to $7,500 each year to an LSA, regardless of income, age or even if you have no earned income. In fact, if you are a parent or grandparent, you can contribute the annual maximum $7,500 to as many accounts for children, grandchildren or anyone as you wish. You cannot contribute more than $7,500 to any one person’s account. A grandparent for example, can contribute $75,000 to 10 different accounts for 10 grandchildren. However, the gift tax rules still apply, unless Congress says otherwise. The annual $7,500 will be indexed to inflation, so that number will gradually increase over the years.
The contributions, similar to a Roth IRA, are nondeductible. But the contributions plus earnings can be withdrawn tax and penalty free at any time for any reason. You don’t have to wait 5 years or until you turn 59 ½ years old like you do with a Roth IRA. There is no holding period on these accounts. This removes the whole 10% early withdrawal problem that has caused excess taxes and has deterred people from contributing to a retirement account.
If you have Archer Medical Savings Accounts (MSAs), Coverdell Education Savings Accounts (formerly Education IRAs), or Qualified State Tuition Plan, they can be converted to LSAs, but only until the end of 2003. Conversions of the MSAs would be taxable since you received a tax deduction when those funds were contributed. But conversions of the Archer or Tuition plans would be tax-free since you never received a tax deduction when you contributed to those accounts.
You can then transfer (up to the $7,500 annual maximum) from your taxable accounts to a tax free LSA so that over time all your taxable savings will be tax free. This provides everyone with a huge incentive to save, with no risk if you need to tap the funds for any reason in the future. Over time, this will reduce the income tax that people will pay on their savings.
Like Roth IRAs, there are no required minimum distributions during your lifetime. However, the proposal is silent as to post death distributions to beneficiaries. Unless there is something that comes out to the contrary, it would seem that post-death distributions would work under the same rules as post death Roth IRA distributions, meaning that your children or grandchildren could stretch distributions tax free over their lifetimes if they wish to.
Retirement Savings Accounts (RSAs)
These can only be used for retirement. RSAs will replace IRAs and Roth IRAs as of January 1, 2004. After 2003, no contributions can be made to traditional IRAs. After 2003 Roth IRAs will cease to exist because they will be renamed RSAs. You can keep your traditional IRA if you do not want to pay the tax to convert it to an RSA, but you cannot contribute new money to a traditional IRA after 2003. However, you could still
roll over your 401(k) or other company plan balances to a traditional IRA and keep it there until you want to convert. No one is required to convert.
When you convert your traditional IRA to an RSA you will owe the income tax on the funds converted (except for nondeductible IRA contributions). But if you convert before January 1, 2004, you can spread the conversion tax over 4 years. There is no limit on how much can be converted if you can afford to pay the tax. There is also no income limit to be eligible to convert, so anyone with an IRA can convert any amount to an RSA.
RSAs also allow annual maximum contributions of $7,500 in addition to the $7,500 you can contribute to an LSA. That’s a total of $15,000 per person, per year, or $30,000 per couple. However, with RSAs you are limited by compensation. If you do not have $7,500 in wages or self-employment income you can only contribute up to the amount of your earned income (or combined earned income if married). If one spouse has at least $15,000 of income, then each spouse can contribute the $7,500 maximum to reach a combined annual $30,000 contribution after you add the $15,000 LSA contribution. Anyone can contribute to your RSA, as long as you have the earned income. So if 10 grandchildren each have at least $7,500 of earned income, then grandpa can contribute $7,500 to each of the 10 grandchildren’s RSAs.
The annual $7,500 will be indexed to inflation, so that number will gradually increase over the years.
Anyone can contribute to your RSA as long as you have the earned income. There are no age or income limits (as long as you have compensation).
Like Roth IRAs there are no required minimum distributions during your lifetime. However, the proposal is silent as to post death distributions to beneficiaries. Unless there is something that comes out to the contrary, it would seem that post-death distributions would work under the same rules as post death Roth IRA distributions, meaning that your children or grandchildren could stretch distributions tax free over their lifetimes if they wish to.
No more ½!
That’s brilliant. They finally found a way to remove the ½ year form the age, but only for 59 ½. The 70½ age for required distributions still exists.
Like LSAs, contributions will not be tax deductible, but unlike LSAs, withdrawals from RSAs do have conditions. You must be at least 58 years old (not 59 ½!) to withdraw tax free or for death or disability.
Employer Retirement Savings Accounts (ERSAs)
These accounts would replace 401(k)s, 403(b)s, governmental 457s, SARSEPs, and SIMPLE-IRAs. The rules for contributions to ERSAs will be simplified and uniform. Top-heavy rules will be repealed which should provide employers with more incentive to offer these plans. Discrimination testing will be streamlined or you could use a new safe harbor provision to avoid discrimination testing.
The proposal includes several questions and answers on how the provisions for LSAs, RSAs and ERSAs would work if enacted as is.
Ed Slott © 2003
Author of:
The Retirement Savings Time Bomb …and How to Defuse It (Viking; 2003)
www.irahelp.com
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