IRA planning opportunities.

Individual retirement accounts (IRAs) are personal retirement savings plans that allow eligible individuals to contribute up to $2,000 per year, both deductibly and nondeductibly with the benefit of tax deferral on the growth and on pretax contributions until withdrawal.

Just prior to the August 1996 congressional recess, four bills were passed containing many significant tax law changes. One of these, the Small Business Job Protection Act of 1996 (SBJPA), made numerous changes to the IRA and pension laws.

Penalty Provisions

Prior law: Prior law contained provisions that assessed onerous penalties under four different sets of circumstances. Penalties are assessed for excess contributions to an IRA. This is a 6% nondeductible penalty, assessed each year that the excess is not withdrawn. A second penalty is assessed for excess distributions from an IRA and other qualified plans. This is a 15% nondeductible tax on total retirement distributions to an individual, during any one calendar year, in excess of a predetermined amount adjusted for inflation ($155,000 for 1996). Individuals with accrued benefits of more than $562,500 on Aug. 1, 1986 are allowed to make a grandfather election that could exempt certain distributions from the excess distributions penalty. The third penalty provision is a 15% Federal estate tax (over the regular Federal estate tax) for excess retirement accumulations. The excess accumulation is the value at the date of death in the decedent's retirement plans over the present value of a single life annuity with annual payments over predetermined amounts. The fourth penalty provision is a 10% excise tax on premature distributions from IRAs and other qualified plans. This penalty generally applies to distributions made before age 59 1/2 (with some exceptions). New law: Sec. 4980A(g), as amended by SBJPA Section 1452(b) (effective for years beginning after 1996 and before 2000), suspends the 15% excess distribution excise tax from IRAs and other qualified plans. This is an extremely valuable planning tool for any client with significant IRA and other retirement accumulations as a result of either corporate rollovers or successful retirement plan growth. The suspension of the 15% penalty on excess distributions not only avoids the excess distribution penalty for the three-year suspension period, but also can allow the taxpayer to reduce the plan total (in order to avoid the 15% penalty on excess retirement accumulations). Planning opportunity: Practitioners should carefully review their client lists to determine which clients may be subject to both the excess distributions and excess retirement accumulations penalties. Projections should be made using reasonable earnings assumptions for clients' current retirement balances and assumptions about their future income tax brackets under different life expectancy scenarios. These projections can be used to explain the likelihood of the application of these two penalties, and a joint decision can be made with the client as to the appropriateness of accelerating IRA and other plan distributions during the three-year suspension period for the excess distributions excise tax. The projections related to this issue are very complex. The factors to be considered include not only assumptions about retirement account earnings, future tax rates and life expectancy, but also present value calculations comparing potential future penalties to current income taxes (which would be voluntarily accelerated if earlier distributions are chosen).

Contribution Limits

Prior law: Prior law limits the maximum allowable IRA contribution to $2,000 or 100% of an individual's compensation or earned income. A second limit of $250 applied to nonworking spousal IRA contributions (spousal IRAs). New law: sec. 219(c), as amended by SBJPA Section 1427(a) (effective for years beginning after 1996), changes the rules and limits associated with contributions to spousal IRAs. Under the new law, in order to make a contribution to a spousal IRA, two conditions must be met: a joint return must be filed and the spouse's compensation (if any) included in gross income for the year must be less than the compensation includible in the gross income of the individual's spouse for the tax year. Furthermore, the limit for the spousal IRA contribution increased to $2,000. The spousal IRA, when combined with the working spouse's IRA, cannot exceed the couple's combined earnings less the working spouse's IRA contribution. Planning opportunity: Practitioners should make sure that clients understand this new provision. Practitioners should project the impact on their clients' retirement assets of increasing their spousal IRA contributions up to the new limits so that the client can make an informed decision as to the benefits of increasing spousal IRA contributions

IRA Withdrawals for Medical

Expenses

Prior law: Prior law, as explained, contains a provision assess, a 10% penalty on early distributions from an IRA. New law: The new law allows two additional exceptions to the penalty on early withdrawals from an IRA. First, the law extends an exception to the 10% penalty for any withdrawal made to pay medical expenses, to the extent the payment does not exceed the amount deductible as a medical expense under Sec. 213 (i.e., medical expenses in excess of 7.5% of adjusted gross income (AGI)). The second new exception applies to withdrawal to pay medical insurance premiums by the unemployed without regard to the 7.5% of AGI floor.