Update: At the time this article was first published, most of the analysts felt that the proposed changes were almost certain to pass quickly.  Now, due to some political maneuvering and controversial amendments to the bill, we anticipate a delay.

Congress is poised to make significant improvements in the tax laws governing 401(k)s 403(b)s, IRAs, and other retirement plans. The new rules will have a dramatic impact on the finances of most taxpayers. By an overwhelming margin (more than enough to sustain a veto) both the House and the Senate support changes that will substantially increase your ability to accumulate wealth and reduce taxes.

Virtually every employee with a retirement plan and practically everyone with an IRA or a Roth IRA will see improvements.  Even individuals who failed to qualify for a Roth IRA under the current law may find that their status has changed.

New Roth 401(k) and Roth 403(b)

One positive development will be the creation of a “qualified plus contribution program” which, for all practical purposes, could have been called a Roth 401(k) or Roth 403(b) plan.  Current participants in 401(k) and 403(b) plans will be able to make contributions to a retirement plan through work, which will have practically all of the tax characteristics of a Roth IRA.  Participants will not receive an income tax deduction for the contribution, but the amount contributed will grow income tax free, quite similar to a Roth IRA.  Presently, many employees are limited to contributions of $10,500 per year to a tax-deferred 401(k) or 403(b).  After the new law is passed and the phase-in period is complete in the year 2005, participants will be able to make contributions of up to $15,000 per year to the new “Roth 401(k) or 403(b).” The “qualified plus contribution program” provides the advantages of a Roth IRA to millions of retirement plan participants who were previously unable to contribute to a Roth IRA account.  My reading of the proposed legislation is that the Roth 401(k) will only apply to the employee's contribution, not the employer's contribution.   In addition, both the Senate and House versions include “catch up” provisions where employees who are age 50 or older would be allowed be make contributions over and above their normal contributions;  either $5,000 per year (Senate version) or a formula percentage based on the annual elective contribution to the retirement plan (House version).

Working individuals, currently limited to an annual Roth IRA contribution of  $2,000, will be eligible for annual contributions of $3,000 for 2001, $4,000 for 2002, and $5,000 for 2003. After 2003 contributions will be indexed for inflation by $500 increments.  The increased contribution limits will also apply to traditional IRAs.  The new rules will also allow participants to put more money in other retirement plans including: Section 457 plans, defined benefit plans, pension and profit sharing plans, top-heavy plans, SIMPLE plans, SEP plans and others. The plans will also be more portable.

The Senate version, though not the House version, includes a change in the modified adjusted gross income limitation from $100,000 to $200,000 for a married taxpayer who wants to make a Roth IRA conversion.

Changes in the Minimum Distribution Rules

Rules governing the minimum required distributions of traditional IRAs, 401(k)s and 403(b)s, both during the life and at the death of the IRA owner, will change significantly.  The changes will have an enormous impact on retirement and estate planning for married retirees who are older than 70½ and have significant retirement assets in their retirement plans. Both the House and Senate versions have revised minimum distribution tables (presumably resulting in lower minimum distributions) but they differ on when these crucial provisions will take effect.

The Senate versionincludes an additional provision that would “permit the election of a new designated beneficiary and method of calculating life expectancy. The regulations would apply regardless of whether minimum distributions had begun.”  The House version has similar language.  This is significant. If the law passes, a taxpayer who is older than 70½ could get a “fresh start” and change the method they are using to calculate their life expectancy, and/or change their beneficiary. This is great news for taxpayers who, stuck with an unfavorable method of calculating their life expectancy, feel their minimum distributions are too high and that they are forced to take out too much money from the tax deferred environment too soon. It is even better news for a plan owner who wants to change a beneficiary because:

• they were predeceased by their spouse, or

• they want to slow down the minimum distribution, or

• they are interested in estate tax savings.

Having the opportunity to change your beneficiary after your elections were supposedly set in stone opens up a host of options and gives you the benefit of 20/20 hindsight.  However, the window to make the change in method and/or beneficiary appears to be open for only one year.  If the House version passes, the one-year window would begin January 1, 2001.  In the Senate version the window opens January 1, 2002.

It could also be great news for a non-spousal heir of an IRA.  In many cases, under the present law, the heir has to take distributions to deplete the entire IRA and pay income taxes on the distributions within a relatively short number of years.  With the new law, the heir would be able to take minimum distributions from the inherited IRA over his/her actual life expectancy.

IRAs and Charity

Rules regarding IRAs and retirement plans and charitable donations will also change.  Retirees (and some who are still working) will be able to make contributions directly from their retirement plan or IRA to a charity without paying any taxes.  Furthermore, individuals will be able to transfer retirement plan assets to a charitable remainder trust (CRT). This type of  CRT pays income to the IRA owner  and/or the IRA owner's  spouse for life, and at death the proceeds go to a charity.

So, what should a tax savvy reader do right now?

• Familiarize yourself with the basic concepts and some of the nuances of traditional IRAs and Roth IRAs.

• Evaluate the economics of Roth IRAs versus traditional IRAs.

• Assess your long-term financial goals and see if you can afford to put more money into these different retirement plans.

• If you are approaching or older than 70½, concentrate on understanding the changes in the minimum required distribution rules and be prepared to make a change in your long-standing distribution pattern.

Watch for more information as it becomes available to develop a better understanding of the relevant issues. Send for my free videotape ($5 for S&H). It addresses the first two issues in detail and includes some discussion of minimum distributions.

Additional Resources

Summaries and detailed descriptions of the bills may be found in PDF files (House: JCX-68-00 and JCX-69-00; Senate: JCX-89-00 and JCX-92-00) at www.house.gov/jct/pubs00.html (Updated 9/7/00).

A side-by-side comparison of the House and Senate version can be found at www.aspa.org/archivepages/gac/2000/Sidersp.htm.

Perhaps the most popular and best website in this area is www.rothira.com.  Periodically checking that website and the accompanying links would probably provide as much or more information than anyone would ever want to know about Roth IRAs and the new legislation.

My web site, www.rothira-advisor.com, has complete articles online that can provide a foundation for your retirement plan education. A video order form is also available online.

James Lange is a tax attorney and CPA with a thriving retirement and estate planning practice in Pittsburgh, Pennsylvania.  He focuses on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, will and trust preparation, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, and his articles are frequently published in Financial Planning, Kiplinger's Retirement Report and The Tax Adviser.