President Bush's proposals offer flexibility and opportunity.

On January 31, the U.S. Treasury announced that President Bush's proposed budget would include provisions for the creation of three new types of savings accounts. Two of the three, the Lifetime Savings Account (LSA) and the Retirement Savings Account (RSA), are targeted at individual savers, while the third, the Employer Retirement Savings Account (ERSA), is aimed at businesses. If these accounts are enacted into law, they will alter the way people save and will create new financial planning opportunities.

As Financial Advisor went to press, there were indications that the proposed accounts are running into some stiff opposition on Capital Hill. But political tides can often reverse in a heartbeat, particularly if a proposal has widespread public support. Indications are that this one does. A recent survey conducted by the Strong Financial Corp. found that 83% of Americans would use one or more of the proposed accounts if they were made available. An impressive 60% of respondents indicated that the new accounts would help them save more. Not surprisingly, LSAs were the top choice of respondents, with 71.3% indicating they would use them.

With the broad media attention the President's proposals are receiving, it behooves advisors to familiarize themselves with the proposed accounts so that they can answer client questions and contemplate outcomes. Even if the proposals are not enacted in 2003, their instant popularity with the public-not to mention with the bear market-battered financial services industry-virtually guarantees they will resurface again.

Lifetime Savings Accounts

LSAs are the most attractive-and the most controversial-of the three proposed accounts. Individuals of any age would be permitted to contribute up to $7,500 annually (indexed for inflation in future years) with no minimum of maximum earned income limitations. Individuals would be able to contribute on behalf of others, so parents and grandparents could fund accounts for children and grandchildren so long as the amount contributed to any one account didn't exceed the maximum annual limit of $7,500 per account. For example, a grandparent with six grandchildren could contribute $45,000 per year on the grandchildren's behalf to six LSAs.

Like a Roth IRA, savers would contribute after-tax dollars to an LSA (but without any income limits). Earnings on the account would be tax free, with no taxes due upon withdrawal. The unique feature of LSAs is that the money can be withdrawn at any time, tax- and penalty-free. There is no minimum holding period and no minimum age requirement, so the flexibility of these accounts is unparalleled.

In a move to simplify the jumble of tax-advantaged plans existing today, the administration proposes allowing taxpayers to convert Coverdell Education Savings Accounts and 529 plans to LSAs, as long as the conversion takes place by the end of 2003. Medical Savings Accounts (MSAs) also would be eligible for conversion, but taxes would be due since the original contribution was with pre-tax dollars.

There would be no required minimum distribution requirement for LSAs during the account holder's lifetime. The proposal doesn't spell out what would happen upon the account holder's death, but presumably post-death distributions would follow rules similar to those for Roth IRAs.

Retirement Savings Accounts (RSAs)

RSAs are designed for retirement savings. Contributions to traditional IRA accounts would cease after 2003, and Roth IRAs would become RSAs. The contribution limits for RSAs would, like LSAs, be $7,500 per year per person (indexed for inflation), but RSA contributions would be limited by compensation. Spouses would be able to use their combined income so if one spouse earned nothing, and the other earned $15,000, each could contribute $7,500 to their respective account. As with LSAs, there is no minimum age requirement, so if a child earned income of $4,000 from an after school job, the parent or grandparent could contribute $4,000 to the child's RSA.

Traditional IRAs will not disappear anytime soon because taxpayers will not be forced to convert accounts. Furthermore, people will still be able to roll money out of a company plan like a 401(k) into a traditional IRA.

Those who do choose to convert will owe income taxes on the amount converted. Nondeductible contributions to a traditional IRA will not be taxed. The government will not place any limits on the amount converted, and no income restrictions will apply; so any IRA will be eligible for conversion. Conversion proceeds will be taxable in the year of conversion with one exception: Conversions completed before January 1, 2004 will be able to pay the conversion tax over four years.

RSAs will be subject to early withdrawal restrictions. Account holders must be at least 58 years old to make tax-free withdrawals. There will be no lifetime distribution requirements, and post-death distribution rules are expected to mirror the current Roth IRA Rules.

Employer Retirement Savings Accounts(ERSAs)

The current law provides for a number of similar tax-advantaged employer-sponsored retirement plans, each with their own rules and regulations. ERSAs would standardize and simplify these plans. Existing 401(k) and thrift plans would be renamed ERSAs and could continue to operate as before, subject to some simplification. Existing SIMPLE 401(k) plans, SIMPLE IRAs, SARSEPs, 403(b) plans and governmental 457 plans could be renamed ERSAs and be subject to ERSA rules, or could continue to be held separately. But if they are held separately, they could not accept any new contributions after December 31, 2004.

According to a U.S. Treasury press release, "ERSAs will follow the existing rules for 401(k) plans, but these rules will be greatly simplified. For example, the definition of compensation and the minimum coverage requirement will be simplified and the top-heavy rules will be repealed. Nondiscrimination requirements for ERSA contributions will be satisfied by a single test, and many firms may choose to adapt a new design-based safe harbor to avoid this test altogether." The proposal would not affect the rules applicable to defined benefit plans.

New Business Opportunities

IRA expert Ed Slott sees tremendous opportunities for financial planners if the President's proposals become law. "If all of this or even some of this makes it into law, then there will be all sorts of transition rules, grandfather rules and distribution rules to advise clients on. There will also be new estate planning opportunities to explore. Financial planners and estate planning attorneys will have more business than they can handle. Investment advisors, particularly those with wealthy clients, will benefit because over time, they will have more money to manage."

Robert S. Keebler, CPA, MST, of Virchow, Krause & Co. LLP, in Green Bay, Wis., sees a number of planning opportunities for wealthy individuals. "Assuming that the distribution rules for LSAs and RSAs are similar to the current Roth IRA regulations, many clients will want to place their RSAs and LSAs into a trust. A trust arrangement will offer two primary benefits: 1) Creditor protection and 2) The ability to include spendthrift provisions in the trust." He envisions parents and grandparents making use of the annual gift exclusion (currently $11,000 per person per donee), to fund LSA accounts and possibly RSA accounts for their children and grandchildren.

Keebler also sees the new accounts potentially "opening the floodgates for conversions from tax-deferred accounts, such as traditional IRAs, to the new savings vehicles."

"The window of opportunity for all account holders to convert and spread tax payments over four years is an added incentive," he says. "I'd need to see what the actual statutes say about re-characterization (undoing the conversion) before advising clients, but if the re-characterization rules were the same as the Roth IRA re-characterization rules, I don't see much downside in converting early because you retain the ability to re-characterize if necessary."

Probable Contributions Strategies

Individual clients will need help deciding where to deposit their retirement savings. As a general rule, clients eligible for any type of a match in their ERSA should first contribute at least enough to capture the full match. After that, assuming a constant tax bracket pre- and post-retirement, LSAs would appear to be the preferred savings vehicle because of their liberal contribution and withdrawal characteristics, as well as their tax-free status. Once a client's LSA is maxed out, they can contribute another $7,500 to an RSA; however, the decision would not always an obvious one. R. Saxon Birdsong, of Baltimore-Washington Financial Advisors Inc., says that on an after-tax contribution basis his analysis shows that clients would be better off contributing to the ERSA if they need to draw down the funds during retirement, but wealthy individuals who do not require the cash flow during retirement will be better off with the RSA. Clients who expect to be in a lower tax bracket post retirement will also be better off maximizing their contributions to ERSA plans before making contributions to RSAs.

Dubious Assumptions

Some commentators have suggested that the new accounts would greatly reduce annuity sales, but that is not necessarily true. While annuities will likely lose their allure as a tax deferral vehicle, the new accounts might actually increase their appeal as a source of cash flow during retirement that cannot be outlived. The guaranteed death benefit will still appeal to many.

There's also a question about the effect these new savings vehicles would have on small-business retirement plans. Some have suggested that there would be less incentive for small businesses to maintain existing qualified plans or to start new ones. Bruce J. Temkin, MSPA, EA, foresees a different scenario: "I spent over 80 hours analyzing the President's proposals, and I think qualified defined contribution plans will continue to appeal to many small businesses. The new bill would have a much more liberal safe harbor provision, so in many cases it will be easier for every employee, including the highest-paid employees, to maximize their plan contributions each year." Temkin suggests that most business owners will want to use a three-step process when analyzing their retirement savings options.

First, determine whether or not an ERSA plan is worthwhile. There may be nonmonetary reasons, such as employee retention, that motivate an employer to establish or continue an employer-sponsored plan. Employers who are able to save more than $15,000 per year may want to use an ERSA plan in addition to their LSA and RSA if the costs of funding employee accounts under the safe-harbor rules are not prohibitive.

Second, examine using LSAs and RSAs exclusively. If the individual plans are sufficient, and there is a desire to help employees fund retirement, the owner could pay out regular bonuses and allow employees to fund their own LSAs/RSAs in lieu of a company-sponsored plan. In the case of very small plans with high embedded expenses, low-paid employees might actually benefit from such a shift.

Third, small-business owners can investigate cross-tested cash balance plans, which often offer owners the opportunity to contribute substantial sums as a low staff cost.

Joel P. Bruckenstein, CFP, is co-author of the book Virtual Office Tools for the High-Margin Practice: How Client-Centered Financial Advisers Can Cut Paperwork, Overhead, and Wasted Hours.