By Mark Miller
March 1 (Reuters) - Talk about an easy lay-up shot. Buried in President Obama’s 2013 budget is a proposed tax break that would make retirement easier to manage for half of America’s seniors - at very low cost to government coffers.
The administration proposes exempting seniors from the rules requiring them to take distributions from tax-deferred retirement accounts starting at age 70½, so long as their total balances don’t exceed $75,000. The exemption would benefit fully half of the owners over that age of IRA, 401(k) and other tax-deferred accounts from the required minimum distribution (RMD) rules.
Distributions from these accounts are taxed as ordinary income in the year of withdrawal. The proposal would simplify tax compliance for seniors - a significant benefit, since failure to comply with RMD rules triggers a 50 percent penalty on whatever funds should have been withdrawn in a given year.
“From a planning standpoint, you have to take the RMD, because the penalty is the worst excise tax in existence,” says Rande Spiegelman, vice president of financial planning at Charles Schwab.
The change also would give seniors greater flexibility in determining when to draw down their savings. Some would be able to delay withdrawals, allowing their accounts to stay invested and continue to grow.
“It’s only a proposal, so it’s hard to know where it will go this year,” IRA expert Ed Slott says. “But it’s a very positive idea, because it would remove unnecessary complexity for millions of seniors. If it doesn’t make it this year, I hope it will somewhere down the road,” he adds. “I don’t know who would be against it.”
IRAs and 401(k)s are designed to provide tax deferral during retirement savers’ working years. The RMD rules are meant to ensure that the funds are used for retirement, and not passed along to heirs.
Almost all seniors with tax-deferred holdings of $75,000 or less spend that money to support themselves in retirement, rather than passing the money on to heirs. That means the impact on tax collections would be minor. The administration projects the lost tax revenue at $355 million over 10 years. If approved, the new tax rule would be effective for taxpayers who reach age 70½ on or after Dec. 31 this year.
The rule would exclude amounts in plans paid into annuities - a proposal that ties into another administration proposal to encourage use of annuities in 401(k) and IRAs.
Another RMD rule change was proposed - but dropped - in the U.S. Senate this year. That plan would have limited the time allowed for the liquidation of inherited funds from IRAs or 401(k)s. (). Currently, heirs can choose between taking a lump sum distribution, or stretching out distributions over many years. Heirs who do take the longer-range distributions from these so-called “stretch IRAs” can, in turn, pass on the accounts to their own beneficiaries, allowing the assets to yield tax-sheltered returns for decades. The Senate proposal would have placed a five-year limit on retirement account liquidations.
The future of income tax rates is the most critical question facing IRA and 401(k) owners. Absent any other action, the Bush tax cuts will expire at the end of 2012, which would restore Clinton-era income tax rates on distributions. The top marginal bracket would return to 39.6 percent, with additional brackets at 36 percent, 31 percent, 28 percent and 15 percent. Higher ordinary income rates would take a bigger bite out of withdrawals - and RMDs can push retirees into higher brackets. There’s also a risk that RMDs could trigger higher taxes on Social Security, or high-income surcharges on Medicare premiums.
What will happen to tax rates is anyone’s guess, with control of the White House and Congress up for grabs. But tax rates seem more likely to be higher than lower over time, considering record high federal budget deficits and historically low interest rates.
“I certainly wouldn’t hold my breath waiting for lower rates than we have now,” Spiegelman says.
Spiegelman advises retirees to pay close attention to where they sit in their current tax bracket, and to carefully manage flows out of tax-sheltered accounts to avoid bracket creep.
“If you’re in the 15 percent bracket and you have another $10,000 to go before you move into the next bracket, that’s a reason to take out some money now, right up to the cusp of the next bracket, and take advantage of the lower rate.”
Another option is converting tax-sheltered assets to a Roth IRA, which gets tax payments out of the way.
“Once you convert, your money grows tax free in your lifetime, and you pass along more to your beneficiaries,” Slott says. “Moving to tax-free territory is something I always encourage because it takes the uncertainty about tax out of your planning.”