Retirement Planning After the New Tax Law

E2E: Retirement Planning After New Tax Law

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Understanding the changes can help you help your clients.

By John D. Bledsoe, CFP, CLU, ChFC, AEP, MSFS

On June 7, 2001, President Bush signed H.R.1836 into law. This sweeping new tax law is formally called the Economic Growth and Tax Relief Reconciliation Act of 2001. This makes for a tough acronym, EGTRRA, as in "EGTRRA, EGTRRA, read all about it." This tax bill is the biggest since the mid 1980s making over 400 changes to the tax code. The changes are in four primary areas: income tax, estate tax, educational savings and retirement plans.

Sunset provision

Most people have heard about the sunset provision in this law. In simple English, this means the entire bill disappears at midnight, December 31, 2010. All of the changes, phase-ins and other components are no more, beginning in 2011.

This is caused by the Byrd Rule that governs the Senate. Its purpose is to ensure that plans that involve reductions in taxes or increases in spending extend no longer than 10 years. The way to override the Byrd Rule is to have at least 60 votes from the Senate. Majorities of this magnitude have been very rare. So with congressional sleight of hand, they passed this sweeping legislation with the proviso that it disappear in a decade.

This provision has been greatly criticized as a form of fraud in the estate planning area, because estate taxes are generally levied only at the time of a person's death, which is unpredictable. However, this sunset provision does not negatively affect the retirement planning part of the law and may actually be of benefit. As long as this law is in effect (until 2011 or Congress changes it) our clients can continue to fund their retirement accounts to the maximum allowed by the current law.

Increases in contribution limits

EGTRRA gives us many increases in annual contribution limits for most retirement plans and IRAs. These increases begin in 2002 by a fixed amount. After 2002, this tax law sets forth specific future increases in these limits to a certain point, then indexes these benefits with inflation.

This bill makes a lot of changes in the retirement planning arena. One notable modification is that age now makes a difference as to how much a person can contribute to a retirement plan or IRA. This is cleverly called a catch-up provision. The rationale is that someone might look up at age 50 and say, I have not even begun to save for my retirement. I wonder if I can catch up?" Well, beginning in 2002, the limits on contributions are generally divided into two categories. Imagine it as a very simple rate book. The two categories are for those under 50 and those 50 and over. It will no longer matter whether a person has made maximum retirement contributions in the past; it is based solely on the person's age at the end of the calendar year. Those 50 and over will usually be allowed greater contributions in most retirement plans and IRAs than those under the age of 50.

Let's examine the increases for IRA contributions. Currently, the maximum contribution a person can make to a traditional (regular) or Roth IRA combined is $2,000, regardless of age. The $2,000 limit for IRAs has been the same for 20 years, so these increases are long overdue. Beginning in 2002, a person age 50 or older is allowed to contribute $3,500 to his Roth or traditional IRA. Those under 50 may contribute a maximum of $3,000. These limits remain for IRAs through the end of 2004 and then increase. The IRA contribution limits are illustrated in Table 1.

This new tax bill increases the amount of salary that a participant may elect to defer in four different plan types. These elective deferral plans are 401(k)s, 403(b)s, SEP and 457 plans. Beginning in 2002, all of these plans will allow the same elective deferral maximum, which will make matters easier. The elective deferral maximum will be increased in 2002 to $11,000 for those under 50. For those 50 and over, the deferral maximum will be $12,000. These deferral maximums increase by $1,000 per year through 2006 for individuals under 50, and by $2,000 per year for individuals over 50.

Simple plans became popular because they are easy for small employers to set up and administer. Simple IRA plan annual contribution limits have been increased as well. The elective deferral maximums for simple plans have been increased in 2002 to $7,000 for those under age 50 and $7,500 for those 50 and over. Future scheduled increases for simple plans are shown in Table 2.

You may have noticed that later on, each of these plan contribution limits is scheduled to increase with inflation. The maximum contribution amounts will increase in $500 increments for these plans. Like other things that index with inflation in our tax law, once the inflation amount matches or exceeds the next increment of $500, the following year's maximum is increased to the new amount.

There are several rule changes in retirement plans that take effect in 2002. The maximum compensation used to calculate contributions is increased to $200,000. The maximum annual contribution to a defined contribution plan is now capped at $40,000. Most elective deferrals and higher make-up amounts for those 50 and over do not count against the other formulas in retirement plan contributions, with a few exceptions. The new maximum annual benefit for defined benefit plans increases to $160,000. Plan loans that are made to smaller business owners are now liberalized.

Rollovers are now allowed among 401(k)s, 403(b)s and 457 plans. The plan has to allow it to accept rollovers and account for the rollover amount separately. These three plans now can be rolled over into IRAs. These changes take effect in 2002.

Low-income earners may be eligible to contribute to an IRA and receive a tax credit on their contributions. This is a credit of up to 50 percent of the IRA contribution of $2,000 or less. These credits phase out for single people with income above $25,000, or $50,000 for married couples.

Planning advantages

This new tax law will give us many new opportunities to serve our clients. The increased contribution limits across the board will give our prospects greater opportunities to save for retirement. The extra increases for those 50 or older will be attractive to many. Parents of adult children will often consider making gifts to their children to see that amount applied to their children's retirement accounts. For many small-business owners and the self-employed, creative planning and understanding of this new tax law will allow them to contribute substantially more money to their retirement plans than ever before.

It may be helpful to show your clients and prospects the difference that maximizing just their IRAs over the next 10 years will make, compared to what it would be under the old amount. And what a great time is it to take advantage of the higher limits that are available only from 2002 through 2010, due to the sunset provision. This may be a one-time window of opportunity. The time to help our clients understand and take advantage of these great benefits that EGTTRA provides is now.

John D. Bledsoe, CFP, CLU, ChFC, AEP, MSFS, is founder of John Bledsoe Associates, a Dallas-based estate planning firm. He can be reached at 972-317-0189.

For more information about retirement planning and the new tax laws, call your local association for the availability of NAIFA's first program-in-a-box seminar that features course material by Bledsoe.

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