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The Old Tax Laws on IRAs No Longer Apply

Tracy Byrnes

01/20/01 - 10:51 AM EST
Anyone who has ever studied tax law in school knows one thing to be true: Whatever you learned that semester is useless because tax laws change by the second.

So it should come as no surprise that the Internal Revenue Service has done it again.

"Everything you ever learned about IRAs is all useless trash," says Bill Fleming, director of personal financial services for PricewaterhouseCoopers in Hartford, Conn. Every book you ever bought, every dollar you spent with a tax planner trying to figure out the gritty rules --all wasted money.

In case you haven't heard, for the first time in a while, the U.S. Treasury has proposed changes to the distribution rules for IRAs and other retirement savings vehicles -- like your 401(k) -- that are actually beneficial to taxpayers.

Individual Retirement Accounts allow you to save for retirement. You can contribute a maximum of $2,000 a year, which then grows tax-deferred -- which means you don't pay taxes on the money -- until you take withdrawals in your retirement. You have the option of taking withdrawals as early as age 59, but are required to begin taking them by April 1 of the year after you turn 70 1/2.

Remember, your withdrawals are subject to ordinary income tax and that could be as high as 39.6% in the highest federal tax bracket. So the smaller your required minimum distribution, the smaller your tax hit. In addition, you'll leave more money in the account to compound. You can always take out more than the predetermined distribution without additional penalties if you choose.

But determining that required minimum distribution was incredibly difficult. It depended first on whom or what you selected as the beneficiary of your account and then on which of the three distribution methods you selected. Even worse, once you turned 70 1/2, you were stuck with the distribution method you chose. You could legally change your beneficiary at any time, but the distribution pattern had to stay. (Well, the IRS would have allowed you to change it only if it put you and your loved ones in a worse position. Gotta love those guys.)

So thanks to these arcane rules, leaving the account to your spouse was best because your spouse could roll over the IRA account into his or her name, tax-free, and start a brand-new IRA. Then your spouse could pick a new beneficiary or beneficiaries and a new distribution method and extend the payout of the account.

If you left the IRA to your children or grandchildren, they couldn't do that. They would have been stuck with the distribution method you selected. So that means quicker, bigger tax hits.

Choosing a distribution method and understanding it practically required an actuarial license. But wait! It doesn't matter! Thanks to some unforeseen generosity in Congress, you no longer have these worries. (If you must know these no-longer-important details, click here.)

The minimum distribution payout is now based on a uniform lifetime distribution period -- it doesn't vary with the age of your beneficiary, as it did before the new rules. So now there's one table that will calculate your yearly minimum required distribution. The table is built on the assumption that you are leaving the account to a person who is not your spouse and is 10 years younger, says Martin Nissenbaum, director of income tax planning at Ernst & Young. Just plug in your age and the prior year-end balance of your retirement account or IRA and -- presto! -- your distribution appears.

The only time you may stray from this new standard is if you have a spouse who is more than 10 years younger than you, says Nissenbaum. Then you get a bigger perk -- you have the option of spreading the payments over the longer joint-life expectancy. That means even smaller distributions each year. (Hmm, so maybe it does make sense to date undergrads.)

So you can change your beneficiary as often as you want and that won't affect the payout. Just know that if you haven't picked a beneficiary by the end of the year following your death, your estate must withdraw all the money from your IRA account within five years.

Many more of the bizarre previous rules are now gone thanks to these proposed regs. It used to be that if you used the recalculation method to determine your distribution payout, and your beneficiary died before you, your IRA account had to be emptied by the end of the year following the year of your death. Fortunately that's gone, says Nissenbaum: "Now you can just change your beneficiary." And in the past, if you named your estate as beneficiary and selected the recalculation method, the account again had to be emptied by the end of the year following the year of your death. That, too, is no longer true.

Know that any beneficiary but your spouse still will be subject to estate tax at your death, so these new rules do not affect the estate tax rules.

There are still lots of unanswered questions and scenarios. For instance, it isn't known what happens when you name your estate as your IRA beneficiary under the new regs, so it isn't recommended that you do so at this time, says Nissenbaum.

Stay tuned as the Treasury clears up some of the ambiguity for us.

The final regs are expected to become official on Jan 1, 2002, but the Treasury says you could use them now. The only kicker here is that the new regs say it's up to the IRA's beneficiary or the employer to elect which regs to follow. So your employer could decide not to implement these new rules until the regs are finalized. Then you would have to follow the old rules when determining, say, your 401(k) distribution payout.

But at least for now, know that the only thing you need to do when you set up an IRA is to pick a beneficiary to avoid that silly five-year rule at your death. That's it.

You have more important things to worry about during your retirement. Like whether you want to play a round of golf or take out the yacht.

New Rules on ISO Withholding

The IRS announced Thursday afternoon that employers do not have to withhold income tax or payroll tax on income from disqualifying dispositions of incentive stock options (ISOs) or employee stock purchase plan (ESPP) options exercised before Jan. 1, 2003.

Basically, that means you take home more money and your employer has to dish out less.

You know when you get a bonus, practically 50% of it disappears into some unknown tax land? Well, the same goes for the income from a disqualified disposition of ISO stock or the exercise of an ESPP option. You "disqualify" ISO stock when you exercise your ISOs and sell the stock in less than a year. (See this previous column for more details.) So any money you made selling those shares comes through your Form W-2 -- Wage and Tax Statement and is hit with the same taxes that your regular wages get smacked with. Same goes for the exercise of ESPP options.

So on top of the ordinary income tax withheld, payroll tax -- or FICA (6.2% withheld for Social Security and 1.45% for Medicare) -- was withheld as well.

The guidance on these withholding requirements was a big unknown for a while. As a result, some employers withheld and some did not. The Service has finally cleared things up, says Nissenbaum.

This is better news for your employer, who had to send an equivalent amount of your FICA taxes withheld to Uncle Sam. Now that employers don't have to withhold, they don't have to pay. This new ruling saves employers big money.

But while you may be taking more money home, you aren't escaping the taxman. This income still will be reported in your W-2. That means Uncle Sam knows about it and wants his cut. Because there is no longer withholding on that extra income, you have to cough up the money on your own -- as you do with all your other stock trades.

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