The tax bill that is expected to become law in the next few weeks will force virtually everyone to take a second look at his or her retirement plans. Were you counting on individual retirement accounts (IRAs) to supplement your pension? You'd better look for something to supplement your IRA.
Do you want to retire early? Under tax reform, you may not be able to afford it.
Will the stock options at that booming high-tech company make you a millionaire? Maybe, but you'll have to rejigger some things to live like a millionaire, or even a moderately well-off retiree.
Did you dismiss municipal bonds as a lackluster savings vehicle? Tax reform gives them a new sheen.
Overall, tax reform increases the cost of saving for retirement, even as it reduces the cost of receiving income and spending it now. It is also fairly progressive, helping lower-income groups more than the middle class or wealthy. Many provisions hurt younger workers (below 50) more than those closer to retirement.
Everyone's case is different, and, not surprisingly, tax accountants urge people to have a professional look at their situation, especially if retirement is approaching.
Several provisions lack details and may be altered in the next little while. But here are some of the likely effects on different income and age groups:
Lower-income groups. ``The bill tries to take some of the benefits going to the top end and spread them around,'' says David Certner, a tax lobbyist at the American Association of Retired Persons.
He notes that more people would be brought into pension plans because of tighter coverage rules: The number of employees covered will rise from 56 percent (though in practice it is higher) to 70 percent.
Mobile workers, who are often at the lower end of the salary scale, would get a boost from new vesting provisions, Mr. Certner says. That especially helps women, who tend to stay at the same company for shorter periods than men. About 80 percent of traditional pension plans do not allow employees to receive employer-contributed benefits until they have worked at the company for 10 years.
The new law would bring the minimum time to five years. Graded vesting schedules also change: The new bill would mean employees would be fully vested after seven years, vs. 15 years under current law.
The law would also let retirees receive higher monthly benefits because of new rules integrating social security benefits with private pension benefits. Certner says more than half of all employees are in integrated plans, and he gives this example to show how the new law would benefit them.
At present, if someone were entitled to $500 a month in social security and $300 a month in a company pension, the employer could reduce the pension amount paid by half the social security benefit -- that is, $250. Thus the retiree would receive $550 a month ($500 in social security, $50 in pension). The new law would restrict how much the employer could reduce the pension payment: The employee would receive no less than half the pension amount he had built up (i.e., $150), so the employee would get $650 a month under tax reform.
Middle-income groups. It's harder to single out provisions helping or hurting middle-income workers. On the whole, younger, middle-income earners fare worse than those who are close to retirement.
Obviously, the biggest change would be in the IRA. If a single person has an adjusted gross income of more than $35,000 and participates in an employer-sponsored pension or profit-sharing plan, he or she could no longer deduct $2,000 for contributions to the IRA.
The deduction would be gradually phased out for those with salaries between $25,000 and $35,000. For working couples, the figure is $50,000 -- the phase-out range would start at $40,000 -- and apply when either spouse was in a qualified pension plan.
Tax accountants, however, still recommend putting the maximum amount ($2,000 per person, or $2,250 for couples with one working spouse) into an IRA, since it would earn interest tax-free until it was withdrawn. The accounting firm Peat, Marwick, Mitchell figures that a $2,000 investment subject to taxes and earning 7 percent interest would be worth about $64,000 after 20 years; if the interest is tax exempt, it would be worth about $82,000.
If you fall into that yuppie category, you need to keep track of post-1986 IRA contributions, since you don't want to pay taxes a second time. You would, of course, have to pay tax on earnings that have grown tax-deferred.
An alternative to the IRA is the 401(k), or 403(b) with certain tax-exempt or government organizations. You would still be able to put up to $7,000 ($14,000 if both spouses work at companies that have such a plan) into a 401(k). Under current law, the maximum is $30,000. For a 403(b), the maximum becomes $9,500, less any 401(k) deferrals. The lower maximum affects mainly high-income employees, since only 6 percent of employees contribute more than $7,000 a year.
It will become far more costly, however, to make early withdrawals from your 401(k) and any other company savings plan under tax reform. The law would put the same 10 percent penalty tax as IRAs already have for taking out money before age 59.
Henry Saveth, vice-president at Johnson & Higgins, a compensation consultant, notes that the changes to savings plans and 401(k)s affect young and old differently. Someone older than 59 -- who would not incur the 10 percent penalty tax -- might want to put as much into his 401(k) this year as he can afford, he says. With income tax rates dropping in 1987 and more in '88, the rule of thumb is to load up one's deductions this year and postpone receiving income until the lower rates are in place.
For young people, especially those thinking about buying a house, sending a child to college, or incurring some other major expense down the road, the penalty tax restricts their flexibility.
``If they're starting to sock away a nest egg now for later, they'll have difficulty in getting money out of savings plans and 401(k)s,'' Mr. Saveth says. ``They may want to save through municipal bonds, income stocks, or simply putting money in the bank.''
Municipal bonds allow you to defer taxes on the interest at any time, without a penalty. They are particularly appealing now, since they are paying about the same interest as bonds that aren't tax deferred -- an unusual situation.
Of course, once other instruments begin having higher yields than tax-exempt investments, accountants say, you should consider the taxable instruments. Lower income tax rates, after all, reduce the incentive to shelter income.
Besides, says Harold Dankner, a partner at the Coopers & Lybrand accounting firm, there's a risk to municipal bonds. ``It's great to get 11 or 12 percent interest, but will they get called? There's nothing you can do about that.''
High-income groups. Aside from limit on what highly paid employees can put into their pension funds (i.e., the $7,000 cap on 401(k)s), they also bump up against a limit for what they can take out of their plans once they retire.
A retiree would pay income tax on the money, as under present law, but also a 15 percent surcharge on the amount over $112,500 a year. Though details are still fuzzy, accountants think that the limit applies to all types of retirement income, including IRAs, 401(k)s, savings plans, and employee stock options.
This provision is already socking voluntary deferral compensation plans, says Mr. Dankner at Coopers & Lybrand. ``As soon as you move toward the $112,500 limit, you'll want to cut out'' of such a plan, he says.
This may seem moot to most of us, but Saveth points out that many people who don't think of themselves as upper-income earners will hit the limit. Say you are an employee at a young high-tech company that offers stock options as part of its employee benefits. The stock goes public, the share price takes off -- a common enough event -- leaving the employee sitting on top of a huge retirement distribution.
What to do? Saveth recommends that if possible this employee have lower-growth investments in his or her employer savings plans or 401(k), and ``do your equity investing, which has a potential for high appreciation, outside of the qualified plan.''
Young, highly paid employees also might have to rethink their plans for early retirement. Under current law, someone retiring at age 55 can receive up to $75,000 a year from his company's funded pension fund. Tax reform would drop the maximum to $40,000 a year. (The limits would be $60,200 at 60 years; $72,000 at 62; and $90,000 at 65, which is the current maximum.)
Benefits specialists expect companies to offer unfunded plans as an alternative. Unfunded plans, however, are not guaranteed by the government. With mergers, acquisitions, and bankruptcies, an employee could end up being a creditor of the corporation rather than a recipient of more retirement money.
Tighter ``nondiscrimination rules'' would restrict highly paid executives (earning more than $50,000) from receiving as much income through pension plans as they can under current law. Starting in 1989, if there were not enough lower-paid employees getting benefits from pension plans, fewer highly paid employees would be covered, or they would receive smaller benefits.
This may put employers under pressure to boost benefits at lower salary levels, Saveth says, ``but the fear is that they'll scale back benefits for everyone.''
Then there's the area of lump-sum distributions vs. rolling the money into an IRA or another plan. The special tax treatment for 10-year averaging of lump-sum distributions would change. (People who were age 50 by last Jan. 1 have a choice between current law and the new bill.) The formula would be reduced to five years, which would increase the taxable amount of benefits. Tax rates would be lower, however, so in the end the two may cancel each other out.
Tax analysts won't generalize on whether the new formula makes 10-year averaging more or less attractive. ``The lump-sum option from a financial planning and tax standpoint was always uncertain,'' says Saveth. ``Now with tax reform, that uncertainty has been doubled.'' He and others stress that the only way to decide what to do with a lump-sum distribution is to sit down (preferably with an accountant) and calculate options.
All of this analysis would change, of course, if the tax code changed sometime in the future. ``If you put your money in a [compensation deferral] plan at 28 percent [the maximum rate in 1988], but rates go up to 50 percent by the time you take the money out, you've just made a bad deal,'' notes Dankner at Coopers.
That is not idle speculation, either. Earlier this month, House Ways and Means Committee chairman Dan Rostenkowski said he favored raising tax rates to lower the budget deficit.