Planning around the "success" tax.

While saving for retirement is a worthwhile objective, most people do not do so. For those individuals who have been disciplined, and have saved and properly invested their assets, the "reward" is a maze of taxes.

Of particular concern are assets held in retirement plans. Retirement plan assets can be subject to income taxes, estate taxes and, in some cases, an additional "success" tax. In many instances, the total tax liability easily can be 70%, and in some cases it reaches 95%.

The Tax Reform Act of 1986 (TRA) imposed a 15% excise tax on individuals whose taxable distributions from all tax-favored plans exceed certain thresholds. For 1996, the excise tax applies to taxable distributions in excess of $155,000 ($775,000 for lump-sum distributions). These amounts are indexed for inflation. Tax-favored plans include all retirement plans, such as defined benefit and contribution plans, Sec. 401(k) plans, Sec. 403(b) plans, profit-sharing plans, individual retirement accounts (IRAs), simplified employee pensions (SEPs) and stock appreciation rights SEPs (SARSEPs).

The TRA also imposed a 15% excise tax on estates with "excess retirement accumulations." This tax is imposed by increasing the estate tax that otherwise would be due. When coupled with the 55% maximum estate tax, large qualified plans can face up to a 70% tax rate before any income tax considerations. The excise tax cannot be sheltered by the unified tax credit or the unlimited marital deduction, although a special election is available for a spouse designated as the beneficiary. Therefore, without proper planning, the excise tax can result in a tax when the estate might not otherwise be taxable.

The term "excess retirement accumulations" is defined as the amount by which the decedents aggregate value in all retirement plans exceeds the present value of a hypothetical life annuity. The hypothetical life annuity is based on the annuity factor in Table S of IRS Publication 1457 for 120% of the Federal mid-term rate. The present value is the annuity factor multiplied by the applicable lifetime threshold amount (see Temp. Regs. Sec. 54.4981A-1T, d-7). This hypothetical life annuity is calculated as a single life annuity with annual payments equal to $155,000 for 1996. The interest rate is the IRS rate for valuing an annuity that applies in the month of valuation and the life expectancy is based on the decedent's age in whole years on the date of death. The excise tax might be reduced if a grandfather election was made. The TRA provided a grandfathering from the 15% excise tax of an amount equal to the total of all qualified retirement plans as of Aug. 1, 1986. If a taxpayer had an aggregate amount equal to at least $562,500 and wished to apply the grandfather rules, he must have made an election on his 1987 or 1988 individual income tax return.

Obviously, many variables will affect this calculation, including age, future interest rates, future inflation rates, financial needs, changes in the tax law and tax rates.

Consider the following example, in which more than 75% of the retirement assets are paid out in taxes:

Balance in qualified
  retirement plans
  at death                        $1,500,000
Hypothetical life annuity(*)        (938,091)
Amount subject to excise tax         561,909
  Excise tax @ 15%                    84,286
Amount subject to estate tax
  ($1,500,000 - $84,286)           1,415,714
  Estate tax @ 50%(**)               707,857
Amount subject to income tax
  ($1,500,000 - $707,857)            792,143
  Income tax @ 45%(**)               356,464
Total taxes                        1,148,607
After-tax distribution to heirs      351,393

(*) Assumes the decedent is 70 years of age and the
annuity factor is 6.0522.
(**) Hypothetical tax rate.

New Legislation

President Clinton recently signed the Small Business Job Protection Act of 1996 (SBJPA), which provides that the excise tax on excess distributions will not apply to any distributions received in 1997, 1998 or 1999. (See SBJPA Section 1452(d), amending Sec. 4980A(g).) The excise tax was effectively suspended and thus will apply only to distributions received after 1999. Distributions are considered as made first from nongrandfathered amounts. However, the 15% excise tax still applies on excess retirement accumulations at the estate level.

Taxpayers with large retirement plan balances who could be liable for the excise tax should carefully consider whether to take distributions from their qualified retirement plans in 1997, 1998 or 1999 (while the excise tax is suspended). Although the distributions will be taxed in the years received, this acceleration of income tax might be offset by the avoidance of the excise tax, especially if the distributions were used, in part, to fund any charitable pledges. Further, any income taxes paid on the distribution(s) would not be includible in the taxpayer's estate.