| Home · Online Publications · The Tax Adviser · Online Issues · December 1998 · Table of Contents · Employee Benefits & Pensions | |
| Tax Clinic |
Employee Benefits & Pensions
Practical Advice on Current Issues
Long-Term Care Planning
As the U.S. population ages, many practitioners will deal with long-term care planning for their elderly clients or their clients aging parents. Most older people wish to stay in their homes for as long as possible. However, the reality is that many of these people will some day require assistance with their daily personal needs. Clients may wish to explore various options for long-term care, including how to fund it, various types of facilities available and how to select a care facility.
With medical costs skyrocketing and individuals living longer, people must carefully consider how best to fund an extended stay in a long-term care facility. Generally, there are five options for funding long-term care:
Medicare
Medicare generally is available to individuals who are at least 65 years old and eligible for Social Security benefits; are less than 65 years old, disabled and eligible for Social Security benefits for more than 24 months; or are in end-stage renal disease (permanent kidney failure). Medicare is limited and covers only skilled nursing facility care (SNF), home health services following a hospital or SNF stay, or hospice care. Also, specific requirements apply even for these Medicare-covered costs.
Medicare Supplemental Insurance
Also known as medigap insurance, Medicare supplemental insurance is privately-obtained insurance that covers Medicare deductibles and co-payment amounts. There are 10 traditional types of policies (Types A through J) and two new high-deductible plans that are variations of Plans F and J. (Note: Policy types may vary in Massachusetts, Minnesota and Wisconsin.) Most medigap plans cover a portion of the costs of skilled nursing care when covered by Medicare. Likewise, most plans exclude nursing home coverage.
Medicaid
Medicaid is available to individuals with limited income and assets; needy individuals who qualify for Medicaid generally will have all long-term care expenses paid for. Income and asset limitations are fairly restrictive and vary by state. Income cap states, for instance, limit a Medicaid applicants income to $1,482 or less per month (in 1998) based on Federal guidelines. The asset limitation, in most states, is $2,000, excluding exempt assets. Some exempt assets include (but are not limited to) one home, one car, limited household items and furniture, and term insurance. Some clients may try to transfer assets to their children or heirs in an effort to qualify for Medicaid benefits. States will disallow benefits when transfers of assets occur within 36 months of the date a Medicaid applicant applies for benefits (60 months for some trusts). Additionally, transfers for less than fair market value may be subject to a penalty period. Theoretically, criminal penalties may be imposed on advisers suggesting asset transfers made solely for purposes of qualifying for Medicaid benefits (although there are questions about the legality of these penalties).
Long-Term Care Insurance
Long-term care insurance may be purchased through private insurance companies and may be appropriate for people who want to preserve their personal assets. Most policies require some type of waiting period before benefits will begin. The cost of a long-term care policy may be prohibitive to certain clients, and costs increase as the clients age increases. A long-term care policy should be evaluated using activities of daily living (ADLs). There are six ADLs, such as eating, bathing and dressing. Policies should specify that benefits commence when a policyholder is unable to perform or remember to perform a given number of ADLs for himself (e.g., three of the six ADLs). Long-term care premiums are deductible as medical expenses, subject to the 7.5% adjusted gross income floor and age-based limitations.
There are three basic types of care facilities:
ALFs. ALFs generally are for individuals requiring help with certain ADLs, but who do not require skilled medical care. Many ALFs provide clients with a sense of independence, while assisting them with meals, medical reminders, cleaning and laundry services. They often offer apartment-type rooms to which older people bring their own furniture and belongings. However, when an individual requires skilled medical care, many ALFs require that the individual be moved to a nursing home.
CCRCs. CCRCs are community-type facilities that provide levels of care commensurate with a residents needs. All levels of care are available in CCRCs, which make them appealing to many individuals. CCRCs usually provide social activities, as well as meals, cleaning/laundry services, transportation, crafts, physical therapy, security and infirmary services. CCRCs may be paid for by a monthly fee (similar to rent), an entrance fee plus a monthly charge, or an ownership interest.
Nursing homes. Nursing home care is required when individuals are unable to live independently because of physical or mental impairment. Nursing care facilities should be carefully evaluated, including an analysis of staffing (to determine if it is sufficient to provide adequate care to all residents). Generally, a nursing home must provide a given number of beds for Medicare patients.
Provisions vary significantly from state to state, and practitioners must carefully examine the rules and laws governing their state before giving specific advice. It also is advisable to have an elder law attorney review any contract for an assisted-living facility prior to a client signing an agreement. Additional resources include:
From Marilyn M. Falkenhagen, CPA,
Maxwell Locke & Ritter, P.C., Austin, TX
Nondiscrimination Safe Harbors for Sec. 401(k) Plans
The Small Business Job Protection Act of 1996 (SBJPA), effective for tax years beginning after 1998, provided an alternative for plan sponsors to satisfy their Sec. 401(k) plan nondiscrimination requirements. Plan sponsors who elect to make safe harbor contributions can avoid discrimination testing for their plans. The SBJPA provision treats the actual deferral percentage (ADP) test for employees elective deferrals as being met if the sponsor elects either of two types of safe harbor contributions. The safe harbor (Sec. 401(k)(12)(B)) is a matching contribution, requiring contributions of 100% of an employees elective deferrals up to 3% of compensation, and 50% of an employees elective deferrals from 3% to 5% of compensation. The first matching contribution rate for any highly compensated employee (HCE) may not be greater than the rate for nonhighly compensated employees (NHCEs).
Some variation is permitted in the matching formula if the matching contributions for each level of elective deferrals are at least equal to the rates computed under the formula described. Also, alternative matching formulas may not provide for a higher rate of matching as the level of elective deferrals increases. For example, if a Sec. 401(k) plan currently provides for matching contributions of 150% of elective deferrals up to 2% of compensation, and 50% of elective deferrals from 3% to 4% of compensation, it would not be necessary to modify that formula to meet the safe harbor requirements. A participant would not receive a lower rate of matching contributions at any level of elective deferrals under the plans current formula than under the safe harbor provided in Sec. 401(k)(12)(B). Therefore, no modification of the plans formula would be needed.
The second safe harbor (Sec. 401(k)(12)(C)) is a nonelective contribution of at least 3% of compensation for NHCEs. The contribution is mandatory for all eligible NHCEs, even if they do not elect to make salary deferral contributions.
Regardless of which type of safe harbor contribution is elected, the contribution must be fully vested and subject to the distribution restrictions applicable to elective deferrals under a Sec. 401(k) arrangement. One additional requirement is that plan sponsors must provide eligible employees with notice prior to the beginning of each year, informing them of their rights and obligations under the arrangement.
In addition to the safe harbor described for ADP testing, the SBJPA also provides a safe harbor for meeting the actual contribution percentage (ACP) test. The ACP test applies to matching contributions and employee after-tax contributions.
The ACP safe harbor (Sec. 401(m)(11)) first requires a plan to meet the ADP safe harbor described above. In addition, the plan must meet the following three requirements:
1. Matching contributions may not be made for elective deferrals or employee after-tax contributions greater than 6% of compensation;
2. The matching contribution rate may not increase as the rate of elective deferrals or employee after-tax contributions increases;
3. The matching contribution for HCEs at any rate of elective deferrals or employee after-tax contributions may not be greater than the matching contribution for NHCEs.
The discrimination safe harbors may be beneficial to employers whose matching or nonelective contributions presently equal or exceed the safe harbor requirements or are not significantly less. These employers should consider the effect of 100% vesting of employer contributions. On the other hand, employers who would increase their matching or nonelective contributions to meet the safe harbor requirements should consider whether to incur the increased contribution costs, to have potentially greater allowable elective deferrals for HCEs and avoid the administrative burden of discrimination testing.
The safe harbors may make Sec. 401(k) plans more attractive to small employers, whose HCEs may have previously wanted to make maximum elective deferrals but would probably have been limited (due to low deferral rates by the NHCEs). If an employer currently sponsors a profit-sharing plan, its contribution costs for NHCEs may decrease by converting to a safe harbor Sec. 401(k) plan, while at the same time permitting maximum elective deferralscurrently $10,000 per yearfor each of the HCEs.
The Sec. 401(k) safe harbors offer additional options for plan sponsors. Employers and their advisers should consider the safe harbor alternatives as they design and maintain retirement plans to benefit plan sponsors and their employees, and to comply with IRS requirements.
From Lorna Doversberger, CPA, MT,
Anderson & Whitney, P.C., Greeley, CO
Roth IRAs in Estate Planning
As the Taxpayer Relief Act of 1997 (TRA 97) worked through committees, there was much concern and debate on the future of Social Security and its relationship to the national savings rate. The intent was to encourage individuals to save for special purposes, and the Roth individual retirement account (IRA) emerged as one of the most significant additions to the Code.
Key benefits of the Roth IRA include nontaxable distributions and the absence of a required beginning distribution date. Issues of deferrals, minimum distributions, penalties, qualifications, assumptions, advantages, irrevocable elections, contribution deadlines and tax rates have been focal, as software seems to have proliferated from every imaginable source to assist individuals in evaluating where to direct their contributions and rollovers.
Funded by annual contributions from earned income, the Roth IRA is the focus of working taxpayers. The maximum contribution is $2,000, and is limited by income, filing status and compensation. Keeping in line with the congressional intent, there is neither an age nor plan participation limit. Individuals are indeed encouraged to save today to supplement retirement income.
Although it was called the Taxpayer Relief Act of 1997, the real impetus behind the TRA 97 was balancing the budget. To enhance immediate revenue, the provision to roll over and report income over a four-year spread attracted much attention. This rollover is frequently referred to as a conversion because it is a taxable event; a traditional rollover from one IRA to another is not taxable. By the end of 1998, taxpayers will know if they qualify to make the conversion. Plus, because of the limitations placed on rollover-funded Roth IRAs, they have emerged as attractions to retired as well as working taxpayers. Once the calculations have been evaluated and the incredibly complex rules have been examined, the advantage of paying tax now rather than later becomes apparentnot so much from a saving-to-supplement-retirement-income viewpoint, but considering the benefits of the ultimate transfer of wealth between generations.
The assumption that there is no advantage in paying taxes now versus later comes under scrutiny. Perhaps the most significant variable is the unpredictability of the tax bracket. Since 1913, income tax rates have ranged from 7% to 94%. The provision to take the rollover into income in 1998 allows for a four-year spread. However, the rollover remains available in future years without the spread. If taxpayers are unable to meet the 1998 adjusted gross income (AGI) limitation to qualify for the rollover (Sec. 408A(c)(3)(B)(i) limits AGI to $100,000), the opportunity to report income gradually may be lost. But there is no reason to abandon the quest to pass the wealth, as there remains the issue of Federal estate tax and the complicated income in respect of a decedent calculation.
After retirement needs have been evaluated, the AGI hurdle overcome and the conversion benefits addressed, designated beneficiary choices are made, making it evident that the estate tax will increase (because no distributions have been factored in). There is no history to use in making assumptions and no promise that provisions will not be tinkered with in subsequent laws. Investment returns and inflation factors are mere predictions. As the Roth IRA appreciates, the transfer tax becomes the focus of estate planners, as they seek to create sophisticated vehicles to shelter such ever-increasing assets.
The lack of provision for required minimum lifetime distributions and irrevocable elections, with regard to beneficiaries, remains the real attraction in using the vehicle for estate planning. The IRS Restructuring and Reform Act of 1998 lists a number of technical corrections; none have substantial effect. Most significantly, the taxpayer may elect to have the 1998 conversion entirely included in income currently, rather than ratably over four years. Absent such election, the converted amount is included in gross income over the four-tax-year period beginning in 1998.
When the owner of the Roth IRA dies, there will have been no required beginning date and the benefit will be distributed according to Sec. 401(a)(9)(B). Distribution options include provisions for a surviving spouse or designated beneficiary. If payable to an estate, the entire distribution will be completed by December 31 of the calendar year that includes the fifth anniversary of the owners death. Accordingly, a taxpayer who has made an irrevocable election at age 70½ may choose to convert a benefit to a Roth IRA, thereby taking advantage of an opportunity to change beneficiaries and eliminate an irrevocable election. Feasibly, distributions could be multigenerational.
Sec. 401(a)(9) allows for the creation of either a revocable or an irrevocable trust as the beneficiary of a Roth IRA. A trust can be of tremendous value if properly drafted. In addition to having tax-free distributions, the benefit could be removed from an estate by means of a current gift. Of course, plan distributions will be to a trust, and earnings on the distributions will be subject to income tax. But if earnings are distributed, a distributed net income deduction is available to the trust. Planning will encompass complex reviews of the generation-skipping transfer (GST) tax and allocation of the GST tax exemption, as well as computation of the immediate gift tax implication.
The multitude of variables and unpredictability of future tax and investment-return rates make the decision to pay tax now and form irrevocable trusts a problematic one. Careful planning is extremely important, and apprehensive taxpayers may want to consider hedging. Once the four-year spread on reporting conversion income has passed, transfers of benefits could be staggered over a number of years. Many states have conformed to the Federal provisions, but this is always subject to change.
It has taken most of 1998 for taxpayers to consider and test scenarios regarding retirement plan selections. The technical corrections codified a few ambiguities. Perhaps the macroeconomic effect of tax revenues over the next four years will keep Congress busy tinkering with the Roth IRA. What was envisioned as a supplement to Social Security income in retirement has grown to be perhaps the most efficient estate planning vehicle.
From Rosemary F. Ervin, CPA,
R.D. Hunter and Company LLP, Paramus, NJ
