The enactment of the Tax Reform Act of 1986 eliminated the deductibility of IRAs for specific classes of individuals based on their participation in qualified employer plans and the level of their income. IRA accounts may be established with banks, savings and loans, insurance companies, mutual funds or brokerage firms. However, IRAs will continue to be used as receptacles for funds accumulated in employer plans.

The enactment of the TaxPayer Relief Act of 1997 also gave individuals a new retirement vehicle called the Roth IRA. This is a non-deductible IRA plan, but the funds grow tax-free and there is no minimum distribution - ever.

The 1997 Taxpayer Relief Act also added more flexibility to withdrawals from an IRA. Prior to the Act, IRA accounts, regardless of the source of funds, were subject to a penalty of ten percent if funds were withdrawn prior to age 59 ½, unless the owner became disabled. Effective for post-1996 distributions, the 1997 Tax Law provides another exception for the 10% additional tax, for withdrawals to pay medical expenses that exceed 7.5% of AGI.

In addition, the 10% additional tax will not be applied to withdrawals to pay for medical insurance (without regard to the 7.5%-of-AGI floor) if the individual has received federal or state unemployment compensation for at least 12 weeks, and the withdrawal is made in the year the unemployment compensation is received or the following year. Self-employed individuals, who are not eligible to receive unemployment because of their self-employed status, may also be able to qualify for this exception to the penalty tax. The exception ceases if an individual has been re-employed for at least 60 days.

If withdrawal is not commenced on traditional IRAs by age 70 ½, the penalty is 50% of the minimum amount that should have been withdrawn, less any amount received. Therefore, age 70 ½ is the maximum age to which distribution from a traditional IRA can be postponed.

However, there is no minimum distribution on the Roth IRA. A retiree could continue to allow funds in a Roth IRA to accumulate as a special contingency reserve, and if not used, the balance would be paid to heirs without any income tax. The balance would still be part of the estate, for tax purposes.

Beginning in 1998, the 1997 Taxpayer Relief Act offers three more penalty-free withdrawal options, in addition to disability.

A total of $10,000 during a lifetime may be withdrawn to buy a primary residence for a person, his or her spouse, parents, and even grandparents, children or grandchildren. The person for whom the home is purchased cannot have owned a primary residence for the previous two years.

Money withdrawn must be used within 120 days of distribution for expenses such as settlement charges, financial fees and closing costs. There is no penalty, but the amount withdrawn is still subject to personal income tax.

Penalty-free withdrawals are also permitted for qualified higher education expenses, such as tuition, fees, books, supplies, equipment as well as room and board. Income taxes on withdrawals of earnings and deductible contributions will still be owed, but the 10% penalty is waived.

The third penalty free withdrawal provided is for self-employed health care. There is no penalty for money withdrawn if the funds have grown a minimum of five years. Again, the funds withdrawn are subject to income tax.

An exception was made in the 1997 Tax Law to allow an employee still working to postpone receiving his or her distributions from a traditional IRA, even after the age of 70 ½, until active employment actually ceases.

In addition, a pension plan generally will be required to actuarially increase an employee’s accrued benefit to take into account the period after age 70 ½ in which the employee was not receiving benefits.

Furthermore, all traditional IRA proceeds are taxed as ordinary income for federal and state income tax purposes as the amounts are received. Funds transferred into IRA accounts lose any chance for favorable capital gains tax treatment.

However, so long as funds remain in an IRA there is no tax on the growth. This has encouraged persons to maximize the retention of money inside such plans while consuming funds already subject to tax - generally referred to as "non-qualified" investments. In a Roth IRA, there is no taxation on the growth - ever.

In July of 1992, Congress enacted a provision to require a withholding of 20% of distributions from qualified retirement plans, such as profit sharing, pension, 401(k) plans, etc. This measure was tacked on to the Unemployment Compensation Act, as a funding method. The bill provided a waiver, however, for a transfer directly to another qualified plan, such as an IRA.

Two bills (HR 5745 and HR 5790) were introduced to repeal this provision, but did not pass. In the meanwhile, it would be advisable not to take constructive receipt of plan distributions, but to have them sent from the plan trustee, directly to an IRA account. Most plan trustees are familiar with this requirement and should be able to process the funds transfer quite smoothly.

Effective for taxable years after 1999, favorable five-year forward averaging will no longer be available for computing the taxes on lump sum distributions from qualified retirement plans. Individuals nearing retirement age, who anticipate receiving a distribution from their employer’s retirement plan, should now consider possible planning strategies.

This option allows the retiree to schedule payments from a retirement plan over a period of years, such as 10 or 20. They may be level payments designed to exhaust the fund during the period. The problem with this option is that since Americans are living longer, the retiree might outlive the income!

Another option is to withdraw a portion of the balance plus accruing interest. This provides for a series of payments with diminishing amounts that will expire at the end of the original period of years established. The retiree experiences a declining income in an inflationary economy. Income is going down, not up!

Yet, another installment option removes a portion of the account balance each year based on a fraction. An example would be to remove 1/15^th the first year, 1/14^th the next year and so on until the total balance is finally taken in the fifteenth year. This produces an increasing income, but again there is the danger of outliving the initial period selected.

The fixed income annuity assures a definite amount of monthly income for the rest of one's life. This would be purchased from a commercial life insurance company. Once the annuity is purchased, the payment amount is fixed and never changes. The insurance company guarantees the amount of the payment, regardless of changes in the economy. Life insurance companies use actuarial tables to determine life expectancies and those who die sooner subsidize the extension of payments to those who live longer.

This income-for-life option is suitable for some circumstances - especially for those who have no survivors and concerning sophisticated planning techniques.

The variable annuity provides monthly payments for the rest of the retiree’s life. However, the amount of each payment after the first may vary in amount from month to month. This fluctuation occurs because the funds supporting the annuity are placed in an investment account.

The assets of a variable annuity account are invested primarily in separate accounts that are very similar to mutual funds. These might be expected to grow in value over the long term, although there is no assurance that gains will be achieved. The insurance company guarantees to continue payments of this variable amount as long as the annuitant lives.

The annuity owner can select from a wide variety of funds - large cap stocks, small cap stocks, international, bonds, etc. Most plans permit funds to be shifted between the various funds with little or no fees. Capital gains are not currently taxable inside a variable annuity.

This method of annuitization is most suitable for a person who wishes to maintain the maximum amount within the qualified retirement plan, while continue to have it grow on a tax-deferred basis. Every year the life expectancy is adjusted using the federal Unisex Mortality tables V, VI or VII.

The Life Expectancy Retirement Option (LERO) approach uses an annual re-calculation. An amount equal to one year of that expectancy is removed. For example, if the life expectancy of the retiree (according to federal tables) is 20 years, one-twentieth (5%) is withdrawn. The balance continues to earn interest on a tax-deferred basis.

Next year, the fund will normally have grown due to the addition of investment earnings. Perhaps it is even greater than the year before if the earnings rate is sufficient. In this case, if earnings were 8 percent, the fund would grow by three percent (8-5=3).

Next year, an amount is withdrawn based on the NEW life expectancy - which will not be 20 less 1, or 19, but some number greater than 19, such as 19.2. Using the IRS Tables, a person's life expectancy is never reached, but advances slightly each year.

The LERO method does not require that funds be transferred to an insurance company, although some offer excellent accumulation accounts. The retiree may use an individually directed IRA and have the funds invested in such a manner as to offset inflation and provide diversification when considered with all other personal savings and investments.

This method will be increasingly used by those interested in tax deferral and inflation protection because it not only defers taxes, but it provides for an income that should increase each year to offset, at least partially, the ravages of inflation. Generally, this provides income increases to age 85 with slight reductions thereafter.

Furthermore, the LERO annuitization option permits the retiree to accelerate the distribution if additional funds are needed for medical expenses, long term care, travel or gifting.

Source: Tax Facts 1