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Who Needs Seinfeld, When We Have the Tax Code?
By Stephen J. Butler |
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The laws pertaining to distributions from retirement plans are so complicated as to be just laughable. For example, an employee who was born before 1936 and who participated in their employer's retirement plan before 1974 can receive any company stock in the plan at a flat 20% tax rate. The amount of stock eligible for this treatment is based upon the number of years of participation in the plan prior to 1974. Employees born before 1936 can also elect to take their entire distribution and be taxed as if the money was received in equal installments over ten years --- a huge tax savings over what some poor soul born in 1937 or later would have to pay. At this point, we should be asking, "Who thinks of these things?" What's magic about 1936 or 1974? Whatever happened to "tax simplification?"
Meanwhile, a careful application of new retirement account legislation effective in 2002 offers some surprising opportunities that did not exist previously.
Before going any further, I will point out that a necessary resource for anyone over fifty is the new 4th edition of "IRAs, 401(k)s & Other Retirement Plans Taking Your Money Out." This book by Twila Slesnick and John Suttle is required reading for anyone within fifteen years of accessing their retirement accounts. It is especially important if you think you might be inheriting money from one of these accounts.
Picking through these new rulings yields some startling findings. For example, there is now the opportunity to make grandchildren the beneficiaries of a retirement account, which will then be taxed at children's low tax brackets as the funds trickle out to them over time. Before, anyone dying after age 70 and * would have had their account paid out based on minimum annual required distributions with calculations based upon the life span of the owner of the account.
Congress has always felt that retirement plans should never be available as a means of passing wealth from one generation to the next. However, the application of these new distribution rules combined with massive estate tax reductions essentially perpetuates wealth accumulation in tax-deferred accounts. By comparison, with previous estate tax tables and income tax exposure, a typical retirement account was easily subject to an 80% combined tax at the death of the second spouse when otherwise postponed tax liabilities came due. If we question such a high combined tax we need to realize that tax planning always assumes that the decision impacts the last few dollars of the estate. If we spend or gift estate assets, we are removing the last few dollars that would have been taxed at the highest marginal rates. It's the same "last dollar" mechanism that generates such a high tax savings on money we deposit
into these plans.
As a general rule, money distributed from a retirement plan prior to age 59 and * will be taxed as regular income at the highest marginal rate PLUS about a 12% combined federal and state penalty here in California. However, taking money out of a plan prior to age 59 and * is always of interest to many people sooner or later, and it can be accomplished free of penalties by several different methods. If you leave a job, for instance, and you will be over age 55 by the end of the year, you can take distributions from your employer's plan on a penalty-free basis. You don't have to retire permanently, and, in fact, you can even come back to work for the same employer. The age 55 option, however, is not available with IRA accounts, so the important point here is to understand how the investment advantages of rolling money into an IRA can clash with the objective of avoiding the 12% distribution penalty. Consider the tragedy of an over-55 Enron retiree who left money in Enron's plan to avoid the penalty.
Many people have accomplished some aggressive estate planning with a variety of trusts, and they wish to fold retirement accounts into that planning process. Before the new laws, it was generally counter-productive. Retirement assets were pretty much doomed anyway from an estate-planning and tax standpoint, so the only option for truly avoiding taxes was to give whatever hadn't been spent to a charity. Today, a profusion of private letter rulings issued between 1987 and 2001 offers a signal from the IRS that there is, at least, a "slippery slope" subject to interpretation. This may offer some families a window of opportunity to create a more tax-efficient transfer of retirement assets.
In the final analysis, the issues to consider boil down to some fundamentals. We have three types of retirement accounts: Company plans, IRA's, and Roth IRA's. Options for taking money out of each depend on whether we are under age 55, between 55 and 59 and *, between 59and * and 70 and *, and over 70 and *. If we die, it matters whether or not we are over or under age 70 and *. In all of these age bands, the three different retirement account types can generate different tax consequences.
It pays to try to understand these complicated rules because the right decision applicable to a specific person's situation can generate tens of thousands of dollars in tax savings. And, like medical care these
days, you have to be informed and know when to question authority. An advisor or former employer, for example, may have an interest in having you roll assets into an IRA when it might have been better to leave them in a company plan.
Investors spend too much time worrying about investment performance, which they can do little about over the long term. By comparison, the time spent educating yourself with books like "Taking Your Money Out..." can yield tangible, predictable, positive results. Grinding through this stupefyingly dull material can be made interesting if you tackle your own situation and create a grid or matrix of account types, ages, and "what ifs." Imagine yourself as Jerry Seinfeld or Elaine trying innocently to understand what is being presented by Newman as the government representative. Remember that only Kramer or George would give up early and look for some easy way out. Whatever psychological tricks will get you through the material can make your time worth several thousand dollars per hour.
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