Recent Tax Legislation—Financial and Retirement Planning

The complex federal tax legislation that Congress passed last year—the IRS Restructuring and Reform Act of 1998—creates significant financial and retirement planning opportunities for taxpayers in 1999 and beyond, while also creating some tax traps for the unwary. Despite its name, this new law isn't just about a new organization chart for the IRS. The provisions curbing IRS abuses and giving taxpayers valuable rights if audited have received much publicity. In addition, however, this law also takes up where the Taxpayer Relief Act of 1997 (TRA '97) left off, fine-tuning and adding new provisions to the tax rules on capital gains and losses, IRAs and Roth IRA conversions, sales of a principal residence, education tax incentives, and exceptions to the estate and gift tax. As a result, every taxpayer needs to review whether his or her financial and retirement plans should be revised to maximize tax benefits.

The IRS Restructuring and Reform Act introduces additional rules for computing capital gains and losses. Although the IRS had anticipated many of these changes in its tax forms for 1997, the new law not only makes this treatment official, but also confirms the burden it puts on investors to carefully keep track of capital gains and losses. In an important change to the rules imposed by TRA '97, the new law eliminates the 18-month holding period that was required to obtain the lowest applicable capital gains rate. Now, an asset need only be held "more than 12 months."

The new law also coordinates the lower capital gain rates with other tax rules, such as those for inherited property or short-sale and covered-call option holding periods. Furthermore, under the new law, those who can take advantage of the tax-free rollover treatment for capital gains on small business stock now have the flexibility of using S corporations and partnerships to do so.

One of the more significant tax breaks for homeowners in a long time--the $500,000/$250,000 exclusion of gain on the sale of a principal residence--has just gotten easier to qualify for in certain situations. In particular, those taxpayers on the move who fail to satisfy the full two-year ownership and use requirement may now be entitled to a portion of the tax benefits. These homeowners can now exclude an amount equal to the fraction of the exclusion proportional to their use of the house as a principal residence over the two-year term.

Roth IRAs, which should be considered by virtually every taxpayer, are the recipients of more good news than bad under the new law. The good news is that, starting in the tax year 2005 in determining whether a taxpayer can meet the $100,000 adjusted gross income (AGI) limit for eligibility to convert regular IRAs into Roth Conversion IRAs, individuals over age 70-1/2 may exclude from their AGI computation any required distributions from retirement plans. This provides an important break not only for some current retirees, but also for those planning how to maximize tax benefits when they retire in the future. However, a loophole that unexpectedly allowed immediate, penalty-free withdrawals for Roth Conversion IRAs has been plugged.

The new education tax breaks have also been the focus of some loophole closing. Education IRAs are now generally subject to a penalty tax if they are not used up before the beneficiary reaches age 30, and only taxpayers who are directly obligated on a student loan are allowed to deduct the interest under the new rules.

Those who own small businesses need to reevaluate their financial and estate plans because of changes to the estate tax made by the 1998 Act. The TRA '97 exclusion for family owned businesses has been changed to a deduction from a person's estate and is now coordinated with the gradual increase in the estate tax unified credit scheduled through 2006. The new law also clarifies the rules governing how a business qualifies for family-owned business treatment. Generation-skipping trusts and conservation contributions also may require review as the result of the 1998 Act.

Finally, one word of warning about the new taxpayer rights provision that has been getting much press--the switching of the burden of proof from the taxpayer to the IRS. This rule applies only to certain civil court cases and, more importantly, does not mean that taxpayers should no longer keep meticulous records of their financial transactions.

We would be pleased to assist you in separating the opportunities from the pitfalls in planning your financial and retirement strategies in light of Congress's latest changes to the tax law. In order to maximize the benefits of this new law in 1999 and 2000, most tax planning should begin as soon as possible.