Overlooked Retirement Benefits In Tax Law

The latest tax law beats up on the IRS and gives taxpayers new protections. You know that from the mainstream media. But the media missed some other changes in the tax law that are of immediate importance to many of you. Here’s a summary of the hidden benefits in the law.

Lower capital gains taxes. When the long-term capital gains tax rate was cut to a maximum of 20% a few years ago, the trade off was that investors received the lower tax rate only if an asset was held for more than 18 months.

The new tax law drops the holding period to 12 months. An investment has to be held only 12 months and one day to get the maximum tax rate of 20%. Another bonus is that this change is made retroactively to cover sales made on or after Jan. 1, 1998. That means if you sold an asset earlier this year that was held for more than 12 months but less than 18 months, you just got a big tax cut.

Selling a residence. A 1996 tax law completely overhauled the rules for selling a residence, and the 1997 clarifies a few points in that law.

The 1996 overhaul provided that any one who owned and resided in a home for at least two years in the previous five years can exclude from income up to $250,000 of gain from the sale of the home. Married couples filing jointly can exclude up to $500,000 of gain tax free. This change greatly simplified the rules for excluding gain from the sale of the home and replaced the old rules for rolling over gain and the $125,000 exclusion for those age 55 or older.

But the law was confusing regarding the treatment of those who owned their homes for less than two years. The law allows a partial exclusion if the move was caused by a job change or other extenuating circumstances. But it wasn’t clear how to compute the partial exclusion.

The 1998 law clarifies this situation. Suppose you lived in your home for only one year, then had to move because of your job. You lived in the home for 50% of the required holding period, so you take 50% of the maximum $250,000 exclusion. You are allowed to exclude up to $125,000 of gain ($250,000 if married filing jointly). This change means that most people who get the partial exclusion will get to exclude all of their gain, since homes aren’t likely to appreciate fast enough to exceed the partial exclusion.

Roth IRAs. I’ve been telling you for some time about the advantages of Roth IRAs. Last month I told you how to decide whether or not to convert your regular IRA to a Roth IRA. Well, there were some unclear statements and some clear mistakes in the Roth IRA rules that Congress fixed in the latest tax law. These rules don’t reverse any recommendations I gave you in past issues but might help a number of you who are considering Roth IRAs.

• The “income” from a Roth IRA conversion is not included in your adjusted gross income when deciding whether or not you meet the $100,000 adjusted gross income limit for making a conversion. I told you that’s what the rule was, but some people felt the law wasn’t clear. So Congress made sure there was no mistake. 

• Beginning in 2005, regular IRA distributions in the year of a conversion won’t be counted when determining whether or not you are eligible for a conversion. Currently, distributions in the year of the conversion count against you. That means even if you convert on Jan. 1, any required distributions for the year apparently are included in your AGI. So individuals with larger IRAs might not be able to convert until 2005. 

• You have until your tax return due date(including extensions) to reverse a conversion to a Roth IRA. This is a real benefit to people who aren’t sure if they will get under the $100,000 AGI limit or who aren’t sure if a conversion is right. You can make the conversion by Dec. 31, 1998, then reverse it by April 15, 1999 (August 15 if you file for an automatic extension), if you decide that the conversion isn’t right for you. 

• The four-year averaging provision for conversions made in 1998 now is optional. Under the original law, you were required to report the conversion income over four years. This could be a detriment to someone who anticipated being in a higher tax bracket in the years after the conversion. Now you have the option of reporting all the income in the year of the conversion or spreading it over four years. 

• I told you previously that the law likely was going to be changed so that you could not avoid penalties by converting a regular IRA to a Roth IRA, then begin taking tax-free distributions from the Roth IRA. Under the original law, you could do that. But, as expected, the latest law changed the rules. But the change is more complicated than anticipated, and some of you will be able to make withdrawals without paying taxes or penalties. Here is a summary of the rules: 

  1. If you make a conversion to a Roth IRA and withdraw money within five years after the conversion while you are under age 59½, then you’ll owe a 10% penalty on the distribution.

  2. If you are over age 59½ when taking that post-conversion distribution, there won’t be a penalty.

  3. If you wait more than five years to take a distribution, there won’t be a penalty.

  4. If you did a conversion and are paying the taxes over four years, the taxes will be accelerated if you take a distribution within the first three years. Each year, you must include in income the amount required under the conversion schedule, plus whatever amount you withdrew during the year.

  This alters the schedule for the amount required to be included in income in future years. For example, suppose the conversion required you to include $25,000 in gross income each year for four years. If you take a distribution of $10,000 in the second year, you must include that in gross income along with the regular $25,000 inclusion. But in the fourth year, you include only $15,000 in gross income. If you are under age 59½, the 10% early distribution penalty also would apply in the second year.

These rules are complicated. I recommend that after a conversion you not take money out of a Roth IRA for five years without consulting a tax advisor.

There were a few more changes in this latest tax law. One of these changes will be a great benefit to taxpayers who won’t convert to a Roth IRA in 1998 but might in the future. I’ll tell you about them next month.