IRA PROVISIONS

David A. Littell

The new law makes significant modifications to traditional IRAs—expanding the availability of deductible contributions and allowing withdrawals without penalty for home purchases and educational expenses. In addition, two brand-new types of IRAs are introduced. First, a new retirement savings vehicle known as the Roth IRA provides for after-tax contributions, but all qualifying distributions are tax free. A third IRA, referred to as the educational IRA, is an entirely different type of animal altogether. With this vehicle, an individual can make up to a $500 contribution each year to an irrevocable trust for the benefit of a beneficiary who is under age 18. When the beneficiary receives a distribution for qualifying education expenses, the withdrawal is tax free to the beneficiary—a similar structure to the new Roth IRA. All of the provisions have phaseout limits for individuals with high incomes. All the IRA changes become effective for the 1998 tax year.

Deductible IRA Contributions—Increase in AGI Phaseout Ranges

Current Law: Individuals who are not active participants in an employer-sponsored retirement plan can generally make a $2,000 deductible IRA contribution each year. Active participants, on the other hand, can still make annual contributions of $2,000 but the deduction is phased out when income exceeds a specific threshold level. For single taxpayers the maximum deduction is reduced with adjusted gross income (AGI) in excess of $25,000 and eliminated entirely for income of $35,000 or more. Married taxpayers begin to lose the deduction with income over $40,000 and lose it entirely with income of $50,000 or more. Married participants filing separately begin to lose the deduction with any income at all and lose it entirely when AGI exceeds $10,000. These income levels have not been tied to an inflation index and have remained the same for a number of years.

New Law: The AGI phaseout ranges for deductible contributions to IRAs by active participants are increased. For single persons they increase gradually until they level out in the year 2005 with a phaseout range of $50,000 (partial reduction) to $60,000 (no deduction). For married couples filing jointly the phaseout range does not level off until the year 2007. In that year the phaseout begins at $80,000. Also beginning in 2007 the phaseout for married couples filing jointly occurs pro rata over the next $20,000 of income meaning that the deduction is not phased out entirely until income is $100,000 or more. No changes were made to the phaseout rules for married participants filing separately. Also note that the new law did not change the definition of compensation—which is still AGI with minor adjustments as described in Code Sec. 219(g)(3)(A). The table below shows the phaseout levels for 1998 and later.

Deductible IRA Contributions—Active Participant Attribution for Spouses

Current Law: As discussed above individuals who are active participants in an employer-sponsored retirement plan lose the ability to make deductible contributions to an IRA when income exceeds a specified threshold. A married person has been considered an active participant if either the individual or his or her spouse is an active participant.

New Law: Beginning in 1998 an individual will not be treated as an active participant merely because the individual’s spouse is an active participant. However, such individual’s deductible contribution will begin to phase out if joint AGI exceeds $150,000 and will be gone entirely if AGI is $160,000 or more.

Commentary: This change will mean that many more individuals will be eligible for a $2,000 deductible IRA contribution each year. Remember that in 1996 the spousal IRA rules were changed so that most married couples with one nonworking spouse could make a $2,000 IRA contribution for the working spouse and a $2,000 contribution to a spousal IRA for the nonworking spouse. Last year’s change combined with the modification to the active participant rule means that beginning in 1998, a $2,000 deductible spousal IRA contribution will be available for many nonworking spouses—as well as for working spouses who are not covered by an employer-sponsored retirement plan. Note that in both these cases the deduction for the nonactive participant is reduced if the couple’s AGI is in excess of $150,000, and the deduction is gone entirely if AGI is $160,000 or more.

IRA Distributions Without Penalty—First Homes and Educational Expenses

Current Law: Individuals who receive taxable distributions from IRAs, qualified plans, and 403(b) annuities prior to attaining age 59 1/2 generally have to pay an additional 10 percent excise tax. The law has contained exceptions for benefits paid on account of death, disability, or for the payment of certain medical expenses. Another exception allows substantially equal periodic payments over the remaining life of the participant and a chosen beneficiary.

New Law: The new law adds two new exceptions to the 10 percent early withdrawal excise tax. The new exceptions apply only to IRA distributions (and not distributions from qualified plans and or 403(b) annuities). The first exception is for distributions to pay for acquisition costs of a first home (paid within 120 days of the distribution) for the participant, spouse, or any child, grandchild, or ancestor of the participant or spouse. This exception, however, has a $10,000 lifetime exception per IRA participant. The second exception is to pay for qualified higher education expenses for education furnished to the taxpayer, the taxpayer’s spouse, or any child or grandchild of the taxpayer or taxpayer’s spouse at an eligible educational institution. Qualified expenses include tuition, fees, books, supplies and equipment required for enrollment in a postsecondary educational institution. Qualified expenses are reduced by amounts of any qualified scholarship, educational assistance allowance, or payment for an individual’s educational enrollment, which is excludible from gross income.

Commentary: These new exceptions to the 10 percent penalty tax are quite powerful. Young adults will have an incentive to contribute to IRAs, since they can now be used to save for a first home or educational expenses—in addition to saving for retirement. Even though the first-home buyer exception is limited to $10,000, it is still a meaningful amount since $10,000 can be a downpayment on a first home. Parents and grandparents interested in gifting to family members will like the idea of encouraging their young adult children to contribute the gift to an IRA or Roth IRA (as long as the child has earned income and is otherwise eligible) since the child will have tax benefits from the IRA contribution, and have an incentive not to take withdrawals except for home buying, education (in the case of a traditional IRA), or retirement.

Certain Bullion Not Treated as Collectibles

Current Law: IRA funds cannot be invested in collectibles except for certain coins described in Code Sec. 5112.

New Law: The new law adds two more types of items that are not treated as collectibles. These are (1) a platinum coin described in section 5112(k) of title 31, United States Code, and (2) gold, silver, platinum, or palladium bullion of a quality eligible for a regulated futures contract (as described in section 7 of the Commodity Exchange Act, 7 U.S.C. 7).

Commentary: This provision will be meaningful for those individuals wanting to invest in precious metals within their IRA accounts. It’s unclear whether any IRA trustees other than banks will be in a position to take "physical possession" of the bullion.

New Roth IRA

Present Law: Individuals can make a $2,000 contribution to an IRA each year as long as earned income (wages from personal services) is at least $2,000. For married couples filing jointly, a contribution of $2,000 can be made for each spouse, as long as earned income for the couple is $4,000 or more. As discussed above, in some cases the contributions are deductible. In the traditional IRA, taxes are deferred on accumulated earnings. At the time of distribution, all amounts are treated as ordinary income except for any nondeductible contributions (which are recovered tax free on a pro rata basis).

New Law: The new law introduces the Roth IRA. Now most individuals will have a choice between contributing to either the traditional IRA or the new Roth IRA. The new IRA is tied to the old rules in that total contributions for the year (to either type of IRA) cannot exceed $2,000. Contributions to a Roth IRA are not deductible but distributions are tax free as long as certain eligibility requirements are satisfied. The maximum contribution to a Roth IRA is phased out for individuals with AGI between $95,000 and $110,000 (pro rata reduction over $15,000 income spread) and for joint filers with AGI between $150,000 and $160,000 (pro rata reduction over $10,000 income spread). Unlike traditional IRAs, contributions can be made even after attainment of age 70 1/2, and the minimum distribution rules that require distributions from IRAs beginning at age 70 1/2 do not apply. However, the IRA minimum distribution requirement that applies to payments after the death of the participant does apply to Roth IRAs.

For distributions to be tax free they generally have to be made after the participant attains age 59 1/2, although exceptions exist if payments are made on account of death or disability or are used for qualifying first-time homebuyer expenses. An otherwise eligible distribution won’t be qualified if made within the 5-tax-year period beginning with the first tax year for which a contribution was to an individual’s Roth IRA. If a nonqualifying distribution is made, amounts representing earnings are subject to both income tax and the 10 percent penalty tax that currently applies to early distributions from regular IRAs and other qualified retirement plans. However, it does appear that Roth IRA contributions can be withdrawn first, before earnings are taxed.

Commentary: An individual who is eligible for a deductible IRA contribution will generally want to choose the traditional IRA over the Roth IRA. An exception may be for an individual who is a long way from retirement and in a lower tax bracket today than he or she expects to be in the future (for example, in the 15 percent bracket today but anticipates being in the 39.6 percent bracket at the time of distribution). On the other hand, the Roth IRA is clearly superior to the nondeductible IRA since taxes on the plan’s earnings are avoided and not just deferred. The real strength of the Roth IRA is that it will provide retirees with a tax-free source of income, allowing them more flexibility in how and when they liquidate assets in retirement. The tax-free funds in a Roth IRA can be used in retirement:

• to minimize taxable withdrawals from traditional IRAs or qualified plans
• to minimize taxable income to stay in a lower tax bracket
• as a source of funds to fund life insurance premiums for estate planning purposes
• as a source of liquidity for estate taxes
• to minimize liquidation of other taxable investments such as stocks and mutual funds—which receive a step up if left intact to heirs

Rollovers to a Roth IRA

Current Law: No provision.

New Law: Distributions from one Roth IRA can be rolled over tax free to another Roth IRA. Also, amounts in a traditional IRA can be rolled over to a Roth IRA if the individual’s AGI for the tax year does not exceed $100,000. The dollar limit is the same for both single and married couples filing jointly—marrieds filing separately are not eligible for the rollover. Rollovers from Roth IRAs and conversions from traditional IRAs are subject to the 60-day rollover rules. The once-a-year rollover rule also applies to Roth IRAs but not to conversions from traditional IRAs to Roth IRAs. When an amount is rolled over from a traditional IRA, the distribution is subject to income tax (taxed as ordinary income) but is not subject to the 10 percent early distribution excise tax. Once in the Roth IRA, future growth is not taxed as long as distributions qualify for the income exclusion. If an IRA to Roth IRA rollover occurs in 1998, a special rule allows the taxpayer to pay the required income tax over a 4-year period (beginning with the 1998 tax year). Apparently the amount of tax is calculated using 1998 rates.

Commentary: In the coming months and years, people are going to be scratching their heads about this intriguing idea—pay taxes now to avoid taxes later. Before getting too excited about it, realize that those individuals most interested—singles and couples earning more than $100,000—will not be eligible to do it. For others, the simple answer will be, defer, defer, defer. However, the analysis could get complicated—guesses have to be made regarding future tax rates. Also, a good case can be made for a balanced portfolio, and today many individuals are heavily weighted in retirement income sources that will be considered taxable income. Having a source of nontaxable income protects against future tax rate increases and also gives an individual the ability to take advantage of some of the opportunities described in the previous commentary. Let the debate begin!

Educational IRAs

Current Law: No comparable provision.

New Law: The new law establishes, beginning in 1998, another new type of IRA referred to as an educational IRA. Contributions of up to $500 can be made for children under age 18. The amount that can be contributed is reduced if the taxpayer’s modified AGI (for joint filers) is greater than $150,000 and becomes zero for joint filers with income of $160,000 or more. For single filers the $500 limit is reduced for modified AGI at or greater than $95,000 and is zero for income of $110,000 or more. Also, note that no contribution may be made by any person to an educational IRA for a beneficiary during a year in which a contribution is made by anyone to a qualified state tuition program on the beneficiary’s behalf. Distributions are not included in income to the extent that distributions are used for qualified educational expenses. However, a beneficiary cannot claim a gross income exclusion from an educational IRA in the same year that a HOPE credit or a lifetime learning credit is claimed for the beneficiary. A rollover provision allows amounts held in an educational IRA for one beneficiary to be rolled to the educational IRA of a family member of the beneficiary without tax consequences. If distributions are not used for qualifying educational expenses, taxable distributions will also be subject to a 10 percent penalty tax.

Commentary: The new law provides numerous tax-advantaged ways of defraying the expense of college education. Since many of the provisions are interrelated, figuring out the appropriate course of action is complicated. On the surface the educational IRA looks like a great long-term funding approach, since married couples with income under the phaseout limits can contribute $1,000 for each child. Also, it appears that any other taxpayer whose earnings don’t exceed the phaseout amounts will also be eligible to make contributions (grandparents, aunts and uncles, etc.). On the other hand, planning can get tricky, since the HOPE or lifetime credits cannot be used for the same year that tax-free withdrawals are taken from the IRA. In some ways a qualified state tuition program may be better, since withdrawals do not effect the HOPE tax credit. Since educational IRAs can be rolled into the account of another family member, it’s hard to imagine that they can’t be used for qualified educational expenses at some time. One final factor will be how this vehicle affects the ability of a student to obtain scholarships and loans. For that answer, we will have to wait until the college community reacts to these new options.

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