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08/14/03 - Retirement Planning and The New Tax Law

By: Richard Feldman, CFP, AIF, MBA

The 2003 tax act has several new provisions that may allow you to pay less income tax on your retirement benefits even though no provision in the bill specifically targets retirement income or benefits. For the third time in three years we are left to figure the intricacies of a new tax package. The Jobs & Growth Tax Reconciliation Act of 2003 ("JGTRRA") was signed into law at a White House ceremony on May 28th, 2003. With the signing of the new tax law came a host of planning issues dealing with IRA's, distributions from retirement accounts, and allocation of assets across retirement and non-retirement accounts.

Roth IRA's

The new tax law provides an even greater opportunity for Roth IRA conversions for married couples. The income limit for converting a traditional IRA to a Roth IRA hasn't changed (it is still $100,000 AGI), but spreading the conversion of an IRA to a Roth IRA over multiple tax years at lower tax rates can now mitigate the taxes owed on converting IRA funds.

The new tax law has expanded the 10% and 15% brackets (see tax tables on the last page) for joint filers. A retired couple between the ages of 59 ½ and 70 ½ who have a low adjusted gross income could begin a systematic conversion of their traditional IRA to a Roth IRA in order to use up their 10% & 15% bracket. Suppose a retired couple has projected taxable income of $35,000, with the new joint tax table being expanded to $56,800 they could then convert $21,800 of their traditional IRA to a Roth IRA at a tax cost of $3,270 at a 15% rate. After holding the funds in the Roth IRA for five years, distributions would be tax-free.

Distributions From Retirement Accounts

Conventional retirement planning advice had typically favored the deferral of income tax until required minimum distributions kicked in, thus allowing the funds to compound tax-free.

Money that's withdrawn from an IRA or qualified plan is taxed at a lower rate under the new tax law. The expansion of the 10% and 15% brackets for married couples provide more opportunity to withdraw funds at a lower tax rate. If you have substantial retirement assets and low non-retirement assets than you might want to fully use the 10% and 15% brackets each year before required minimum distributions push you into higher tax brackets. You could then invest these assets in a tax-efficient manner in your non-retirement accounts.

Investment Allocation

The spread between the highest tax bracket rate and the capital gains rate before JGTRRA was 18.6% (38.6 percent less 20 percent). As a result of the new tax law, the spread now increases to 20% (35 percent less 15 percent), making planning for the allocation of investments across taxable and tax-deferred accounts even more important. If you reside in a state that has high local and state taxes the spread is even greater. Throw in the reduction on qualified dividends to 15% or 10% if you are in the 10 or 15 percent bracket and there are a several planning opportunities.

The new law makes it disadvantageous to hold ordinary income-producing investments in taxable accounts, compared with stocks that generate qualified dividends and long-term capital gains (assuming your tax bracket is higher than 15%). In practice we try and shelter ordinary income-producing assets by placing them in retirement accounts as much as possible. For our younger clients we will look to balance the fixed income allocation across retirement and non-retirement accounts by using municipal funds (assuming a high tax bracket) in taxable accounts and a global bond position in the tax-deferred account. The allocation decision should be balanced with the desire for growth or safety in both retirement and non-retirement assets.

Tax Planning

When it comes to tax planning there are no standard solutions. Every individual has their own set of circumstances they should review before making any changes in their current plan. Increasing your AGI might result in more taxes on Social Security benefits or fewer itemized deductions. You should always do a little number crunching with tax software or your CPA before implementing a new strategy.

Whether you love President Bush or hate him, chances are the new tax law will save you some money. Through proper financial planning and allocation of investment assets the amount of tax savings can be increased.

The New 2003 Tax Rate Structure

Summary

The 10% bracket is expanded for all except heads of households. The 15% bracket is expanded for joint filers and married-filing-separate status. The 27% rate is now 25%; 30% rate is now 28%; 35% rate is now 33%; and the 38.5% rate is now 35%. Standard deductions have been increased for joint and married-filingseparate status.

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