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The complex new tax law helps retirement savers--and their tax-return preparers. Photographs by Ken Reid/FPG International

Workers and retirees alike are justifiably concerned about meeting the challenges involved in achieving and maintaining financial security. The combination of long life expectancy, inflation, ambitious life-style aspirations, and employers cutting back on pension plans imposes a significant obstacle to achieving a financially comfortable retirement. And more threats to the retirement dream are looming: although Congress has not yet tinkered with Social Security and Medicare, reductions in both kinds of benefits now seem very likely.

In that light, it is especially important to take advantage of the provisions contained in the Taxpayer Relief Act of 1997. For all its fiendish complexity--the law runs to 800 pages--the act does provide relief for most working-age people trying to accumulate retirement savings, and for many retirees as well. You can pretty much count on being able to take advantage of some of its provisions--once you understand them.

Highlights of the law for retirement savers include higher income limits for those eligible to make tax-deductible individual retirement account (IRA) contributions. Penalty-free withdrawals from IRAs before age 59 1/2 will now be allowed for educational purposes and first-time home purchases. There is also a new IRA option--the Roth IRA; although the contributions aren't tax-deductible, earnings on the IRA are tax-free after five years. And the Roth IRA is available to everyone except those deemed "high income" (that's anyone who earns more than a member of Congress). Finally, investors of all ages will benefit from the reduction in capital-gains tax rates.

To get you started, we present an in-depth look at the new rules on IRAs (and their interaction with employer-sponsored plans), and on capital-gains taxes. Where appropriate, we suggest that you seek professional assistance before making investment or tax-strategy decisions. In the March-April issue, our continuing coverage of retirement finance will review the new rules on taxation of home sales, gifts, and estates.

NEW RULES FOR IRAS

Effective this year, relaxed restrictions and the creation of a new IRA will benefit many investors saving for retirement.

Deductible IRAs will be available to more people. The maximum possible annual contribution to a deductible IRA will still be $2,000 or 100 percent of an individual's compensation (earned income, for the self-employed), whichever is less. And for married couples filing jointly, the maximum possible contribution will still be $2,000 for each spouse if their combined compensation (even if only one spouse earns the money) at least equals the contribution.

But more people will be eligible to make a deductible IRA contribution. Under the former rules, taxpayers were permitted to make the maximum contribution only if their adjusted gross income (AGI) was under $25,000 for individuals ($40,000 for married couples filing a joint return), or if they were not active participants in an employer-sponsored plan during the tax year. For individuals who were plan participants, eligibility to make IRA contributions was phased out--the permitted maximum amount ultimately reduced to zero--as AGI rose from $25,000 to $35,000 for individual filers. For joint filers, the phaseout took place from $40,000 to $50,000--even if only one spouse was an employer-plan participant.

Under the new law, beginning this year, the level of AGI that triggers the phaseout is going to double over the next eight to 10 years. The present $10,000 phaseout range will also expand--for joint filers only--to $20,000 after 2006.

The new law also changes the way phaseout is computed for joint filers. Previously, married persons who didn't have an employer-sponsored plan of their own were nonetheless tainted if their spouse had one. Starting January 1, though, they will no longer face such discrimination, and they won't be phased out unless, or until, the couple's combined AGI is between $150,000 and $160,000.

The new Roth IRAs will have unique advantages. For tax years beginning in 1998, a new type of IRA will be available: the Roth IRA. Although contributions will be made from after-tax income, the Roth IRA will be a powerful vehicle for accumulating retirement income.

Once a Roth IRA has been held, untouched, for five tax years, distributions will not be subject to federal income tax, if they are taken:

on or after age 59;

after death (in which case, the money goes income-tax-free to one's heirs);

on account of disability; or

for first-time home-buyer expenses.

Distributions taken for other purposes before age 59 1/2 will be considered non-qualified distributions, but they still will be federal-tax free up to the amount contributed to the distribution date. If an amount greater than the aggregate contribution is withdrawn, only the gain will be taxable, and the distributions will be treated as made from contributions first. All of an investor's Roth IRAs are aggregated for this purpose, but regular IRA distributions are treated separately. (And remember, the income-tax rules are federal. Some individual states may decide not to follow suit.)

There's more good news. Unlike a regular IRA, a Roth allows you to make contributions after age 70 1/2. You're not required to start making withdrawals at age 70 1/2, either.

The allowable contribution to a Roth IRA is limited for investors whose adjusted gross income exceeds specified dollar amounts. AGI is calculated in much the same way as for a regular IRA, except that the deduction for a regular IRA contribution is allowed as a deduction in computing AGI. Phaseout with a Roth takes place from $95,000 to $110,000 AGI for single taxpayers, $150,000 to $160,000 for joint filers, whether or not investors are active participants in an employer-sponsored plan.

Conversions of non-Roth IRAs to Roth IRAs are permitted. Of all the changes in this most recent round of tax reform, the one that has piqued the most interest--and the most confusion--is the Roth IRA conversion. Conversions from regular IRAs to Roth IRAs will be treated as taxable distributions, although only the earnings and the deductible IRA contributions in the former IRA account will be taxed (not any after-tax IRA contributions in the account). And investors who make qualified conversions during calendar 1998 will receive special treatment: they'll be able to spread out the taxes owed on the distribution equally over four tax years, beginning with 1998.

Not everyone will be allowed to convert a former IRA into a Roth, however. Taxpayers whose AGI exceeds $100,000 (the amount of the money converted into the Roth IRA does not count toward the $100,000 limit), and spouses who file separately, may not make a conversion during that taxable year.

Two more categories of qualified distributions from IRAs have been created. Beginning this year, owners of regular IRAs will be able to take premature distributions without the usual 10 percent penalty in order to pay qualified higher education expenses of the taxpayer or spouse, or child or grandchild (not necessarily a dependent) of the taxpayer or spouse. The exempt amount will be reduced, however, if one of the new education tax credits is taken in the same tax year.

Also beginning in 1998, owners of both regular and Roth accounts will be able to withdraw up to $10,000 during their lifetime for first-time home-buyer expenses without paying the 10 percent penalty. A distribution taken for this purpose must be used within 120 days after it's received. The one-year waiting period normally required between rollovers will not apply.

A first-time home buyer is defined not as someone who is buying his or her first home, but as an individual (and spouse, if any) having no ownership interest in a principal residence during the two-year period ending on the date construction begins on a new principal residence, or a binding contract to buy a home is signed.

The law is not explicit, but it appears that two or more individuals, including married couples, who qualify as first-time home buyers and who purchase a principal residence together will each be able to take up to $10,000 from their individual IRAs without incurring the early withdrawal penalty.

The despised 15 percent excise tax on large retirement-plan accumulations has been repealed. The new regulations no longer discourage you from saving a lot for retirement. The legislation repealed the 15 percent excise tax that had been imposed on people who were amassing substantial amounts in retirement plans--in effect, penalizing successful retirement savers.

What does it all mean? Make strategic choices. When choosing an IRA for a short-term investment, the old-fashioned deductible IRA may be the better bet. But for long-term holdings--and the longer the better--the Roth will be unbeatable. It's simply not possible for a one-time tax break on $2,000 to even begin to compete with 20 or 30 years of compounding, tax-free earnings on that same $2,000 which can also be withdrawn tax free.

Obviously, younger investors can potentially reap the greatest rewards from their Roths, but eligible investors of any age who don't qualify for a tax-deductible IRA and whose income is within the limits to qualify for a Roth IRA should establish one as early as possible in 1998 and contribute as much as they can every year, up to the $2,000 limit.

If you have an IRA, should you convert it into a Roth? That depends. You'll be taxed on any earnings from the old IRA, so it might take years before the Roth catches up. It will be important for anyone considering a conversion to analyze the ramifications very carefully before proceeding. Individual circumstances will vary widely, of course, but generally, conversions will make the most sense for younger investors with high earnings who anticipate a high retirement income-tax bracket. Also, to make a conversion to a Roth IRA financially advantageous, you should pay the taxes with funds outside the IRA. Be sure to ask a tax professional to analyze your situation to see if you would benefit by converting to a Roth.

What if you have a 401(k) or 403(b) plan at work? If your employer matches contributions, it probably will make sense to invest enough in the plan to get the maximum match. On the other hand, if your employer doesn't match contributions, it may make more sense to fund a Roth first unless you think you need the enforced discipline of payroll deductions. (If you can afford it, of course, you should contribute the maximum to both your employer-sponsored plan and a Roth IRA.)

What if you're self-employed and have a Simplified Employee Pension (SEP) plan or Keogh Plan? Those tax-deductible plans allow larger contributions, but if you can afford it, you should try to contribute the maximum permitted to both the deductible plan and a Roth IRA. If you can't afford it, and you expect to be in the same or higher tax bracket when you retire, then you may want to make the maximum contribution to a Roth first. If you expect to be in a lower bracket, though, or if you're close to retirement, you'll probably be better off to fund the deductible plan first.

REDUCTION IN CAPITAL-GAINS

TAX RATES

Lowered capital-gains tax rates will benefit nearly every investor in stocks and stock funds. Though it comes with some strings attached, the lower long-term capital-gains tax rate will benefit investors who plan carefully. But many investors will need to alter their strategies to take maximum advantage of the changes.

Under the new rules, you can realize three different types of capital gains carrying three different tax rates:

Short-term gains: assets held for a year or less, taxed at ordinary income rates, which can be as high as 39.6 percent.

Mid-term gains: assets held more than a year but not more than 18 months, taxed at a maximum 28 percent rate.

Long-term gains: assets held more than 18 months, taxed at a maximum rate of 20 percent (10 percent for taxpayers in the 15 percent income-tax bracket).

Some assets will not be eligible. There are exclusions to the lower rates. Collectibles, for example, will still be taxed at a maximum 28 percent. Also, 50 percent of the long-term gain on qualified small business stock held for more than five years will continue to be excluded from gross income, and the remaining 50 percent will continue to be taxed at a maximum 28 percent rate, for an ongoing effective maximum capital-gains tax rate of 14 percent for this class of asset.

Capital gains on depreciable real property, such as residential rental property, will be excluded from the lower rates to the extent allowable depreciation is taken before the property is sold. In effect, the amount of the gain that is attributable to depreciation will be taxed at 25 percent.

Strategy implications for investors. Active traders may see less benefit from the new capital-gains tax rates, but buy-and-hold investors will have an increased advantage, given the longer holding periods required for the lower rates. Growth stocks and low-turnover stock funds should become even more attractive, while dividend- and interest-income investments will lose some of their appeal. And one common tax strategy, concentrating stocks in tax-deferred accounts while holding fixed-income securities in taxable accounts, merits a fresh look now that capital-gains rates are generally so much more favorable than ordinary income-tax rates.

It will still make sense for most active traders and investors in high-turnover stock funds that make frequent distributions of short- and mid-term realized capital gains, to hold their investments in retirement accounts to avoid the 28 percent (or higher) capital-gains tax on investments held less than 18 months.

Buy-and-hold stock investors should start evaluating possible outcomes of holding their stocks in retirement accounts. Ditto for investors in low-turnover stock funds, which will probably be reporting fairly high long-term capital gains compared with high-turnover funds whose capital gains are likely to be primarily short- or mid-term. The guiding principle under the new tax rules is to put those investments that are likely to incur the lower 20 percent capital-gains rate into taxable accounts and investments that are subject to higher taxes (including corporate and government bonds) into retirement accounts. Why? Because most or all of the gains from individual stocks held for more than 18 months and low-turnover stock funds are subject to the new 20 percent tax rate--unless they're held in a tax-deferred account, which could eventually subject these gains to tax rates of 28 percent to as high as 39.6 percent. Remember, most or all of the withdrawals from retirement accounts are subject to taxes at ordinary income-tax rates--not the capital-gains rate.

The new rates' impact on retirement planning will therefore be significant. Investors who are in the top 39.6 income-tax bracket when they retire will pay nearly double their capital-gains rate on any withdrawals from tax-deferred retirement accounts. (Roth IRAs are an exception, as explained above.)

WHAT'S THE UPSHOT?

Because the new tax rules are so complicated, you should anticipate having to spend some time just trying to learn what they are before you can assess their implications for your investment strategy. You will probably want to make at least a few changes, but there's time to make well-considered decisions. Overall, the news is good (especially for tax-return preparers!), and results should be gratifying for savvy investors--particularly those pursuing a long-term horizon, such as accumulating savings for retirement.