Uncle Sam doesn’t usually give taxpayers a chance to simply wipe the slate clean and start over. But that is exactly what Congress is proposing for folks whose retirement distributions are messed up due to paperwork mistakes, poor beneficiary choices or other snafus.
Tucked away virtually unnoticed in the massive pension legislation working its way through Congress are provisions that could enable retirees and their heirs to keep money in tax-sheltered retirement plans longer, and thus potentially provide them millions in tax savings.
“It’s a sleeper, but this is going to be the big story of this legislation,” says Seymour Goldberg, a Garden City, N.Y., tax attorney. Others agree, noting that the bill provides relief from a system that is becoming increasingly unenforceable.
The problem is that decisions made about minimum distributions from individual retirement accounts and most other tax-favored retirement plans become irrevocable once a person reaches age 70 1/2. As a result, a growing number of people are finding themselves locked in by decisions made five, 10 or even 15 years ago. They can’t change their decisions, even though those choices may be forcing money out of retirement plans earlier than otherwise necessary, cutting short the tax-deferred growth of those funds while creating huge income-tax bills.
The worst cases typically involve people who have no idea what choices they made because either they or their IRA provider misplaced the paperwork.
The legislation would give everyone a chance to start fresh. It directs the Treasury Department to update, simplify and finalize retirement-plan distribution rules by Dec. 31, 2001. Then, probably starting Jan. 1, 2002, people with retirement plans would have a one-year window to choose new beneficiaries and select different distribution methods to update their plans to take advantage of the new rules.
Versions of pension legislation have passed the House and a Senate committee in recent weeks, and the Clinton administration also has expressed cautious interest in the issue.
A spokesman for Senate Majority Leader Trent Lott (R.-Miss.) described the legislation recently as being “at the top of the list of issues we’d like to get addressed.” The measure got hung up in Congress, but it is likely to be one of the measures included this week in a last-minute package of spending and other bills.
A new beginning could mean big savings. Consider a 71-year-old man who named no beneficiary and chose a distribution formula that recalculated his life expectancy every year. With a $100,000 IRA growing at 7 percent a year, that IRA would produce about $185,800 if the man follows current life-expectancy tables and lives 15.3 more years, says Marvin Rotenberg, national director of retirement services at Fleet Private Clients Group in Boston.
But if the man used the proposed one-year window to name his 18-year-old grandchild as beneficiary, that same IRA could be stretched out for 62.8 years because of the grandchild’s longer life expectancy. That would produce distributions totaling about $1.8 million.
A second provision, which would take effect Jan. 1, 2001, would allow people who inherited IRAs and other retirement plans to get out from under any mistakes Mom or Dad may have made while alive. Rather than be saddled with leftover calculations established by the original plan owners, beneficiaries would simply use their own life expectancies to set distributions. The only requirement for taking advantage of this provision: The IRA owner must have named a designated beneficiary.
“If anything, this bill brings to everyone’s attention the importance of naming a beneficiary,” says Ed Slott, a Rockville Centre, N.Y., accountant and publisher of Ed Slott’s IRA Advisor.
Even those who inherit retirement plans from people who never designate a beneficiary would get a modest reprieve, he says. Instead of having all funds forced out of the IRA by Dec. 31 of the year after the owner’s death, the new legislation would allow the heir in this situation to spread distributions over five years.
The third provision in the proposed law provides some relief for people who don’t take required distributions on time. Now faced with a 50 percent penalty on late distributions, retirement-plan owners would see that penalty, now rarely enforced, drop to a mere 10 percent. The change would be a boon to older people who often simply forget that they have to take their distribution.
This provision has already prompted some aggressive planners to suggest people might deliberately decline to take their distributions because they know there is only a 10 percent penalty. But David W. Polstra, an Atlanta financial planner, calls this a bad idea. The Internal Revenue Service, he says, could “simply disqualify the IRA,” wiping out the tax-deferred status for the entire plan.
By calling on the Treasury actually to finalize rules, Congress is clearly saying it is tired of waiting. Although many people may not know it, the rules IRA providers and owners have been following in making decisions affecting billions of dollars of retirement-plan distributions are merely proposed. The IRS issued them over 13 years ago but hasn’t ever finalized them.
Under the circumstances, some expect that the proposed one-year window could be far too short. “These provisions have been there for 13 years and millions of people haven’t figured it out yet,” says Natalie B. Choate, an attorney with the law firm Bingham Dana in Boston. “It is totally hopeless to think a one-year window is going to solve the problem.”
There is also the question of whether the financial community could process the paperwork in a single year. Under the present proposal, IRA providers will clearly be under the gun. Not only will they have to revise all of their forms, but they will also have to process huge numbers of changes.
IRA owners will also have to hustle to make sure that they make the necessary changes, and make them properly. Once Uncle Sam gives people a chance to clean up their acts, the IRS will be more likely to crack down on abuses, explains Slott.
“If you have a second chance,” he says, “you would hate to blow it.”
