Estate taxes and retirement plans.

One of the more important aspects of estate tax planning involves the treatment of retirement plans. In many cases, funds accumulated in the form of retirement benefits can make up a significant portion of an estate and should be an integral part of estate planning.

When dealing with estate planning and taxes involving retirement plans, there are several elections to remember.

The Tax Reform Act of 1984 repealed the exclusion from gross estates of qualified retirement plan benefits attributable to employer contributions. This applied to individuals who died on or after Jan. 1, 1985. However, it is still possible to exclude part or all of the value from the gross estate if certain requirements are met and elections were made.

In order to gain such exclusion for annuities, the decedent must have been a participant in the retirement plan and have received at least one benefit payment on or before Dec. 31, 1984, or must have separated from service before Jan. 1, 1985 without changing the form of benefit before dying. If either of these conditions is met, an exclusion of up to $100,000 is allowed.

There is also an opportunity to gain an unlimited exclusion, if the decedent was a participant in the retirement plan and had received at least one benefit payment on or before Dec. 31, 1992 and irrevocably elected the form of benefit before Jan. 1, 1983, or if he separated from service before Jan. 1, 1983 and did not change the form of benefit before death. If either of these conditions applies, the $100,000 limit to the exclusion does not apply.

A few years later, the Tax Reform Act of 1986 liberalized the grandfathering provisions by providing that the participant no longer needs to be in pay status as of the applicable date.

Sec. 4980A imposes an excise tax of 15% on excess distributions from qualified employer plans and individual retirement plans (defined in Sec. 4980A(c)(1)) and excess accumulations (defined in Sec. 4980A(d)(3)). This excise tax generally applies to excess distributions made after Dec. 31, 1986, and the excise tax on excess accumulations applies to estates of decedents dying after Dec. 31, 1986.

An "excess retirement accumulation" is the excess of the aggregate value of the decedent's interests in all qualified retirement plans and individual retirement accounts (IRAs) as of the date of the decedent's death (decedent's aggregate interest), over an amount equal to the present day value of a life annuity.

An eligible individual could have elected to reduce the tax burden by using a special grandfather rule. The elections must have been made on Form 5329, Additional Taxes Attributable to Qualified Retirement Plans (Including IRAs), Annuities, and Modified Endowment Contracts (Under Section 72, 4973, 4974 and 4980A of the Internal Revenue Code), and filed (by the due date, including extensions) with the individual's income tax return for 1987 or 1988. To make the grandfather election, the individual must have had at least $562,500 in aggregate benefits as of Aug. 1, 1986. If this special rule applies, the decedent's excess accumulation may be reduced if there is any unused benefit as of the date of death. Making the grandfather election does not eliminate the potential excise tax, since the grandfathered amount is included to determine if the excise tax applies. In other words, total accumulated retirement benefits determine if the threshold is exceeded. If the benefits are subject to the excise tax, the grandfathered amount reduces the total that would be subject to the excise tax. Under the special grandfather rule, the decedent's excess accumulation is the excess of (1) the decedent's aggregate interest over (2) the greater of (i) the decedent's remaining unrecovered grandfathered amount as of the decedent's death or (ii) an amount equal to the present value of a life annuity.

The determination of the additional tax under Sec. 4980A(d) is illustrated by the following examples.

Example 1: Individual A dies on Feb. 1, 1994 at age 70 and nine months. As of A's date of death, he has an interest in a defined benefit plan described in Sec. 401(a) (Plan X). X has never provided for employee contributions. A has no Sec. 72(f) investment in X. A does not have any interest in any other qualified employer plan or IRA. The alternate valuation date in Sec. 2032 does not apply. A did not elect to have the special grandfather rule apply. A's interest in X is in the form of a qualified joint and survivor annuity. The value of the remaining payments under the joint and survivor annuity as of A's date of death is $2,000,000.

Because A is age 70 and nine months on his date of death is calculated using age 70 (A's attained age in whole years on his date of death). The factor from Table A of Regs. Sec. 20.2031-7A(d) used to determine the present value of a single life annuity for an individual age 70 is 6.0522. The greater of $150,000 or $112,500 (indexed for 1994) is $150,000. The present value of the hypothetical single life annuity is $907,830 ($150,000 X 6.0522).

The amount of A's excess accumulation is $1,092, 170 ($2,000,000 (value of A's interest in X) -- $907,830 (value of hypothetical single life annuity contract)).

The increase in the estate tax under Sec. 4980A(d) is $163,826 (15% of $1,092,170).

Example 2: The facts are the same as in Example 1, except that A elected the special grandfather rule. A's initial grandfathered amount was $1,100,000. As of A's date of death, A had received $500,000 in distributions that were treated as a return of A's grandfathered amount. Thus, A's unused grandfathered amount is $600,000 ($1,100,000 -- $500,000). In 1994, $112,500 indexed is $148,500.

A's excess retirement accumulation is determined as follows: $2,000,000 minus the greater of (1) $600,000 or (2) the present value of a period certain annuity of $148,500 a year for 16 years (A's life expectancy). The present value of a single life annuity of $148,500 a year for an individual age 70 is determined as follows: $148,500 X 6.0522 = $898,751.70. Since $898,751.70 is greater than $600,000, the amount of the excess retirement accumulation is $1,101,248 ($2,000,000 -- $898,752).

The additional estate tax under Sec. 4980A(d) is $165,187 (15% of $1,101,248).

Example 3: The facts are the same as in Example 2 except that, as of A's date of death, A received $90,000 in distributions that were treated as a return on A's grandfathered amount. Thus, A's unused grandfathered amount is $1,010,000 ($1,100,000 --$90,000).

A's excess retirement accumulation is determined as follows: $2,000,000 minus the greater of (1) $1,010,000 (A's unused grandfathered amount) or (2) $898,751.70 (the present value of a single life annuity of $148,500 a year for an individual age 70). A's unused grandfathered amount is greater than the present value of a life annuity. Thus, the amount of the excess retirement accumulation is $990,000 ($2,000,000 -- $1,010,000).

The additional estate tax under Sec. 4980A(d) is $148,500 (15% of $990,000).

Even though the deadlines for the grandfather elections have passed, there are other areas of planning to be considered in dealing with the excise tax.

As part of an overall estate plan, advisers should continually monitor accumulations in retirement plans and remember that annual distributions could be made in order to lessen or eliminate the potential excise tax on the estate. For example, an individual may want to begin distributions before attaining age 70 1/2 in order to reduce accumulate benefits, or possibly before age 59 1/2 without incurring any early withdrawal penalty (as long as the individual meets certain requirements and the distributions are made over his life expectancy at the time). Extraordinary investment returns at any particular time could suddenly expose retirement benefits to the excise tax should the individual die.

If, despite other planning, the decedent still has an excess retirement accumulation, the special spousal election should be considered. Sec. 4980A(d)(5) permits deferment of the excise tax if the surviving spouse is the beneficiary of all but a de minimis portion of all benefits. The spouse may elect (by attaching a signed statement to the estate tax return) not to have the special estate-level tax apply and to have the distributions received with respect to the decedent aggregated with any distributions that the spouse received on the spouse's own behalf. As with any election, the potential benefits must be weighed against other consequences, such as precluding the use of a credit shelter trust for the plan funds.

It is important that tax advisers be aware of these elections and their impact on estate planning for their clients.