Retirement and Taxes

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By Roy Lewis
January 18, 2002

One of the major changes to the tax law under the Economic Growth and Tax Relief Reconciliation Act of 2001 has to do with retirement plans and other deferred-savings plans. Make no mistake -- these changes are substantial (though not as great as some would have liked). But there are many tax-saving opportunities built into the new laws. Let's take a look at some of the major provisions.

IRA contribution limits
The annual contribution limits for both traditional and Roth IRAs will increase from $2,000 to $5,000. This increase will be phased in over several years. Here's how the contribution limits will look:

  • 2002 through 2004: $3,000 max contributions
  • 2005 through 2007: $4,000 max contributions
  • 2008: $5,000 max contribution

After 2008, the maximum contribution amount will be adjusted for inflation. What does this mean to you? It means that in 2002 your maximum IRA contribution limit will increase by 50% over the currently allowable $2,000. And in 2008, when the full increases are in place, your maximum IRA contribution limit will have increased a whopping 150% over the former limit of $2,000. Before you blanch at the size of these increases, remember that maximum IRA contribution limitations haven't increased for more than 20 years. So much of this increase is nothing more than catching up for Congressional inactivity.

IRA catch-up contributions
Those of you who are age 50 and above will be permitted to make additional contributions to your IRAs.  How much and when? Check this out:

  • 2002 through 2005: $500
  • 2006 and thereafter: $1,000

Remember that the catch-up provisions apply to regular IRAs and Roth IRAs, but the AGI limits for deductibility of traditional IRA contributions and eligibility for Roth IRA contributions are still in play. You can also mix and match your regular contributions and your catch-up contributions as you see fit... some to your traditional IRA and some to your Roth IRA. If you're eligible for the catch-up provisions, this means that you can make a $5,000 contribution to your IRA in 2006. And by 2008, your maximum contribution will increase to $6,000. If you were delinquent in making IRA contributions early in your earning life, these catch-up provisions can help to ease the pain by permitting you to save more in tax-deferred and/or tax-free accounts.

Deferred compensation contribution limits
These will also increase over time. These increases will apply to 401(k), 403(b), 457 plans, and Salary Reduction SEP (SARSEP) Plans. The maximum contribution limits will be increased as follows:

  • 2002: $11,000
  • 2003: $12,000
  • 2004: $13,000
  • 2005: $14,000
  • 2006: $15,000

After 2006, the maximum contributions will be indexed for inflation. And there are also catch-up provisions for these types of plans. Beginning in 2002, for workers age 50 and older, the catch-up amount that can be contributed will amount to $1,000, and will increase by $1,000 each year until 2006 (resulting in a $5,000 catch-up). After that, the catch-up amount will be indexed for inflation. And these catch-up provisions are in play even if your contributions would otherwise be limited, even if the limitation is caused by non-discrimination provisions or a limit based on your percentage of compensation. So in 2006, if you're age 50 or older at that time, your maximum contribution to your 401(k) or similar plan could be as much as $20,000 -- $15,000 in regular contributions and $5,000 in catch-up contributions. 

SIMPLE plan contributions
SIMPLE plan limitations were also increased, along with catch-up provisions. They look like this:

        Simple Limits     Catch-Up Limits
2002       $7,000               $500
2003       $8,000             $1,000
2004       $9,000             $1,500
2005      $10,000             $2,000
2006      Indexed             $2,500
Future    Indexed            Indexed

Contribution tax credit
Beginning in 2002, lower-income taxpayers will receive an additional credit (up to 50% of the contribution) for virtually any contribution made to a retirement account, including 401(k) plans, 403(b) plans, and IRAs (both traditional and Roth). While this is a wonderful idea in theory, the income limits are set so low that most of the people targeted with this credit likely won't have enough discretionary income to save for retirement. Another problem is that many of the lower-income taxpayers might not have a tax liability anyway. So this credit might be more sizzle than steak. If you're interested, get more information here.

Employer plan benefits
If you're an employer, you'll be pleased to know that you'll be able to offer even more generous retirement benefits to your employees (and to yourself, of course). Why? Because beginning in 2002:

  • The current $35,000 limit for defined-contribution plans will rise to $40,000.
  • The $140,000 annual benefit limit for defined-benefit plans will rise to $160,000.
  • The $170,000 limit on compensation that can be taken into account will rise to $200,000.

Other changes make it easier for employers to offer more benefits. For example, the deduction limit for contributions to profit-sharing or stock-bonus plans has been increased from 15% to 25%. Additionally, there are other provisions that will make it easier for employers to offer more benefits to employees. Not only that, the new law includes numerous measures to increase protection of plan participants, including shortening of vesting schedules, enhancing portability of pension assets, and permitting workers to become vested and eligible for employer matching contributions in three years rather than five.

Danger! Danger!
With all of this good news, there is still a fly in the ointment for many investors. While Uncle Sammy may expand pension contributions, there are still a number of states that have not yet conformed their state tax rules to the federal rules. What does that mean? If you live in one of the states that has not yet conformed to the federal law changes, you might be stuck with the old pension contribution rules. As of this writing, the states that have not conformed to the federal rules appear are Alabama, Arizona, Arkansas, California, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Massachusetts, Minnesota, New Jersey, North Carolina, Pennsylvania, South Carolina, West Virginia, and Wisconsin.

If your state is still stuck under the old rules, what will happen if you want to make a $3,000 IRA contribution? It's impossible to know for sure, since state tax law varies. But it's possible that the extra contribution would be deemed an excess contribution. Your $3,000 federal deduction might only be a $2,000 state deduction with a $1,000 excess state contribution subject to penalties. In other states the additional contribution to a 401(k) plan might be deemed taxable income for state purposes. Or worse yet, the additional contribution might disqualify the entire plan for state purposes, and cause a deemed distribution.

The rules can get even more tricky if you make contributions in a conforming state and then decide to retire in a non-conforming state, and vice-versa.

You can read more about this in a terrific article written by Kathy M. Kristof in the Los Angeles Times. While the article deals primarily with California taxpayers, there is a great discussion that might apply to residents of all non-conforming states. If you do live in one of the non-conforming states noted above, pay close attention to how your state legislature plans to deal with this issue.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.   

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