What the Taxpayer Relief
Act of 1997 means to you
What the Taxpayer Relief
Act of 1997 means to you
by Robert B. Coplan & Robert Garner
Ernst & Young
Financial Planning Reporter
On August 5, 1997, President Clinton signed the Taxpayer Relief Act of 1997 (" '97 Act"), the most significant overhaul of federal tax laws since the 1986 Tax Reform Act. This article deals with the IRA changes, the Roth IRAs, Education IRAs and other tax legislation affecting higher education funding.
IRAs Grab The Spotlight Again
IRAs have been around for many years.
Since 1986, however, the rules regarding the deductibility of IRA contributions
have been restrictive. Nevertheless, these vehicles have maintained their
appeal, because investment earnings accumulating within an IRA are not subject
to tax until withdrawal. Tax-deferred investing can be a powerful tool in
the creation of wealth.
The '97 Act not only loosens the reins a bit regarding the deductibility of IRA contributions, it creates new fax-favored savings opportunities using IRAs in accumulating wealth for education and retirement goals, as well as a first-time home purchase.
IRA Contribution Deductions
In general, up to $2,000 ($4,000 for married couples) of IRA contributions are deductible annually. However, if either you or your spouse is an active participant in a qualified retirement plan sponsored by your employer (or you, if self-employed), IRA deductions currently start to phase out when adjusted gross income (AGI) reaches $25,000 for single taxpayers and $40,000 for married couples filing jointly. The deduction is completely phased out when AGI reaches $35,000 and $50,000, respectively.
Starting in 1998, the '97 Act makes two important changes here: (1) It gradually increases the AGI levels at which the IRA contribution deduction starts to phase out until they reach $50,000 and $80,000, for single and joint filers, respectively (see Table 1); and (2) An individual will no longer be considered an "active participant" in a qualified retirement plan simply because his or her spouse is. Thus, even if your spouse were-but you were not-an active participant, you could still deduct up to $2,000 of IRA contributions annually. Note, however, that this allowance is also phased out between $150,000 and $160,000 of AGI.
New Roth IRAs
Also starting in 1998, retirement savers
will have another tax-favored vehicle to consider: the "Roth IRA."
A Roth IRA is a nondeductible IRA that allows you to accumulate earnings
on an entirely tax-free basis-provided the funds are used for qualified
purposes. Like other IRAs, the maximum annual contribution is limited to
$2,000 (or $4,000 for married couples filing jointly), less the total
amounts contributed to other deductible and nondeductible IRAs. In addition,
contributions to Roth IRAs are phased out between $95,000-$110,000 of AGI
for single taxpayers and $150,000-$160,000 for joint filers.
So long as funds are not distributed from a Roth IRA during the first five taxable years starting with the year the account is established, distributions made by reason of the account holder reaching age 59-1/2, due to the death or disability of the account holder, or for first-time homebuyer expenses (subject to a lifetime cap of $10,000) can be received tax-free. Distributions not meeting the above requirements are still considered nontaxable to the extent of your cumulative contributions to the account(s)-that is, as long as you don't dip into accumulated earnings.
Choosing Between A Traditional IRA And A Roth IRA
If you're eligible to contribute to either
a traditional, deductible IRA or a Roth IRA, your decision should
depend on your personal tax situation and considerations of when you want
to make withdrawals. The traditional, deductible IRA will give you an immediate
tax deduction and tax-deferred earnings, but will imposed income
tax later (on contributions plus earnings) when you take a withdrawal. The
Roth IRA will not provide a tax deduction, but will offer tax-free earnings.
In general, the Roth IRA will be superior to a deductible IRA in saving for retirement, after taxes are considered. This is especially true if you are a long way off from retirement. On the other hand, if you're close to retirement and planning to start withdrawing funds from your IRA within the next few years, or if you expect your tax bracket to be significantly lower during retirement, a deductible IRA might outperform a Roth IRA. (See Table 2 for a comparison example.) It pays to "run the numbers" to see which IRA would be best for your situation.
If your choice is between contributing to a traditional, nondeductible IRA and a Roth IRA, the Roth IRA is clearly superior because of its advantages of providing tax-free earnings, the ability to withdraw contributions at any age without penalty, the ability to make contributions to the account past age 70-1/2, and the lack of mandatory distribution requirements during the account owner's lifetime.
Converting An Existing IRA To A Roth IRA
The '97 Act also allows you to "convert"
an existing IRA to a Roth IRA, starting in 1998, by paying tax as if you
had distributed the existing IRA in full. However, only taxpayers with AGI
of $100,000 or less can take advantage of this planning technique. Note
that the 10-percent early withdrawal penalty tax does not apply to the amount
of the "deemed" IRA distribution on the conversion. In addition,
any amount converted to a Roth IRA before 1999 can be included in your income,
for tax purposes, evenly over a four-year period (starting with the 1998
tax year).
Deciding whether to convert an existing IRA to a Roth IRA generally depends on the same factors as the "deductible IRA vs. Roth IRA contribution" decision. In general, a conversion makes sense if you're at least several years from retirement and won't need the money before age 59-1/2, or you expect to be in a higher tax bracket after retirement. Because the conversion will require you to pay tax earlier than if you just left the IRA alone, you'll need sufficient time to allow the Roth IRA to accumulate enough tax-free earnings to outweigh the time value of money costs of paying the conversion tax (see Table 3 for an example).
If you can, use funds outside of your IRA to pay the conversion tax, since that'll keep more money growing tax-free within the Roth IRA. Although you can use funds from the IRA to pay the tax if you don't have enough non-IRA funds, doing so will likely extend the amount of time necessary to recoup the up-front tax cost of conversion.
Education IRAs
The '97 Act includes numerous tax incentives for funding the costs of higher education. It creates yet another new IRA, dubbed the "Education IRA," for accumulating education funds on a tax-favored basis. Starting in 1998, you can contribute up to $500 annually to an Education IRA for the benefit of each family member under age 18, in case one child decides not to attend college or receives a scholarship. Although the contributions are non-deductible, investment earnings grow on a tax-free basis. Distributions from the account are tax-free up to the amount of "qualified higher education expenses" paid that year by the person for whom the account is maintained.
In addition, funds from one Education
IRA can be rolled over tax-free to an Education IRA maintained for another
family member. In any case, funds not used for education purposes must be
distributed by the time the account beneficiary reaches age 30. Distributions
not used for qualified education purposes are subject to tax under the normal
IRA distribution rules, including the 10 percent early withdrawal penalty.
Similar to Roth IRAs, contribution allowances for Education IRAs are phased out between $95,000-$110,000 of AGI for single taxpayers and $150,000-$160,000 for married couples filing jointly. In addition, if anyone has made a contribution to a qualified state tuition program (discussed below) on behalf of another individual, no contributions may be made to an Education IRA maintained for the benefit of that same individual in the same year.
New 10% Early Withdrawal Penalty Exceptions. The '97 Act also provides that, starting in 1998, if you take an otherwise taxable distribution from an IRA and use it to fund a) qualified higher education expenses incurred after 1997 (including graduate level courses) for yourself or your spouse, child, or grandchild, or b) acquisition costs of a principal residence for the purchase of a first-time home for yourself, your spouse, child or grandchild, you will not be subject to the 10 percent early withdrawal penalty. For these purposes, a qualified first-time homebuyer is someone who has had no ownership interest in a residence during the past two years. Note that the qualified home-purchase exception does not apply to Education IRAs.
Collectible Restrictions Lifted. The new law also relaxes the IRA investment restrictions regarding certain collectibles by allowing IRA funds to be invested in certain gold, silver and platinum coins and bullion, starting in 1998.
Others Ways To Fund The Costs Of Higher Education
In addition to creating the New Education IRAs, the '97 Act includes other provisions designed to help families defray some of the costs of higher education. Unfortunately, the interplay of these provisions with federal, state and school-specific financial aid formulas will make the financial aid application process more complex for many families. In addition, since tax reductions result in an increase in "net income," some families might see their aid reduced due to any newly available tax credits and/or exclusions.
First, starting in 1998, the new law introduces two new nonrefundable education tax credits that are based on a percentage of qualifying "higher education expenses" paid on behalf of a student family member: 1) The Hope credit; and 2) the Lifetime Learning credit. Detailed explanations of these credits, including AGI phaseout ranges, will be included in The Ernst & Young Tax Savers Guide 1998. What's important to note here, however, is that a taxpayer cannot claim either of these credits in the same year he or she elects to exclude an Education IRA distribution from gross income with respect to the same student. Determining which provisions will provide your family with the most benefits will, therefore, require a thorough analysis of the alternatives.
The '97 Act also modifies some of the tax treatment applicable to qualified state tuition programs, which were granted tax-exempt status under the Small Business Job Protection Act of 1996. These are programs established and maintained by a state (or agency or instrumentality thereof) under which persons may 1) purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary, or 2) make contributions to an account that is established for the purpose of meeting qualified higher education expenses of the account beneficiary.
Under the new law, the definition of "qualified higher education expenses" is expanded (effective retroactively to August 20, 1996) to include certain room and board expenses-which can significantly add to the costs of higher education. In addition, for estate and gift tax purposes, any contribution to a qualified tuition program or Education IRA made after August 5, 1997, will be treated as a completed gift from the contributor to the beneficiary at the time of the contribution, and is eligible for the annual gift tax exclusion.
The adoption of somewhat favorable tax rules for prepaid tuition plans in 1996 has led to a proliferation of such state plans, and more are on the way. The expansion of the provisions to permit room, and board payments, and the ability to have payments qualify for the gift tax annual exclusion will add to the attraction of the plans.
Repeal Of The 15 Percent "Success" Taxes
If you've been worrying about how deeply
Uncle Sam will dip into your ever-growing qualified retirement plans and
IRAs, you can now rest a little easier. While distributions from these accounts
are still subject to income tax (with the notable exception of qualifying
Roth IRA distributions) during life and transfer taxes upon your death,
no longer do you have to contend with the additional 15 percent excise tax
on excess distributions and excess accumulations. Effective for distributions
made after December 31, 1996, and for decedents dying after that date, the
'97 Act repeals these so-called "success" taxes.
With the total elimination of the success taxes, we return to an environment where maximizing the deferral of tax becomes the optimal planning strategy for most taxpayers. Making the right choices at the retirement plan participant's required beginning date (RBD) for making minimum distributions (generally April 1 in the year following the year he or she turns age 70-1/2-especially the selection of a designated beneficiary -- should maximize the participant's opportunity for continued tax deferral, during life and following death.
Nevertheless, for some taxpayers, accelerating retirement distributions prior to the RBD (and paying the related income taxes) may produce greater wealth over the long term if the after-tax distributions can be invested at a higher after-tax rate outside of the plan-either due to lower effective capital gains rates or to superior investment opportunities.
Editor's Note: Robert Coplan and Robert Garner are editors of the Ernst & Young Financial Planning Reporter, P.O. Box 33337, Washington, D.C. 20033, 1 year, 6 issues, $96.
Because the matters covered herein are complicated, the
Reporter should not be regarded as offering a complete explanation and should
not be used for making decisions. Any suggestion should be reviewed with
your personal financial and tax advisor.
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