Planning for large retirement savings at death: payout strategies for minimizing taxes.

The various retirement tax-deferred savings vehicles (TDVs) provided in the tax law (e.g., Sec. 401(k) plans, individual retirement arrangements (IRAs)) are generally very advantageous. By deferring tax on income accumulated in TDVs, taxpayers can generate a larger after-tax income stream at retirement than would otherwise have been possible. However, one consequence of using TDVs is that funds remaining in them at the saver's death may be subject to estate tax, income tax and, possibly, excess accumulations tax. This article discusses the benefits of using TDVs, the tax consequences when funds remain in them at death, and planning to mitigate those consequences.

Lifetime Advantages of Using TDVs

There are at least two major advantages to saving through TDVs: they allow a taxpayer to (1) generate a larger future income stream by accumulating more assets and (2) shift income from a higher bracket (during working years) to a lower one (during retirement years). Example 1: Individual X has $1. His combined Federal (39.6%) and state (0.4%) tax rate is 40%; his rate of return on a 20-year investment is 10%. Thus, after taxes, X has 60 cents to invest. This will grow at an after-tax rate of 6% (0.10 (1.00 - 0.4)), yielding $1.92 at the end of 20 years; after that time, it will generate an after-tax income stream of $0.12 ($1.92 x 0.06) per year. if the dollar were instead saved in a TDV, the pre-tax yield would be $6.73 ($4.04 after taxes) at the end of 20 years; the $1 would generate an after-tax income stream of $0.40 ($6.73 X 0.061 per year thereafter. The deferral allows X to more than double the after-tax value of his retirement assets, or triple the retirement income generated by the discretionary dollar. The increase is a function of the tax rate, the rate of return and the savings period.

The second advantage of tax deferral occurs only if X earns $1 when it would otherwise have been subject to a 40% tax rate and collects it when his marginal tax rate is zero. Actually realizing this is unlikely; to achieve it, X would have to earn more than $256,500 of taxable income while saving and have TDV income less than his personal exemption and standard deduction during retirement. X would more likely drop to a 28% bracket at retirement than the zero bracket. In fact, heavy use of TDVs by a taxpayer may result in no decrease in tax rate at retirement and may raise the tax rate because of the 85% inclusion of Social Security income.

Consequences of TDV Savings at Death

Generally at death, $1 left to an heir results in an actual bequest of anywhere from 40 cents to $1, depending on the decedent's estate tax rate. if no estate tax is owed, the heir receives $1; if the decedent's estate is taxed at the highest marginal estate tax rate (60%), the heir receives 40 cents. This simple result becomes more complicated if the bequeathed dollar is in a TDV, because then, the dollar is subject not only to estate tax, but also to income tax as Sec. 691 income in respect of a decedent (IRD). The beneficiary will be entitled to an income tax deduction for the estate tax paid on the dollar (under Sec. 691(c)(1)), but the deduction may be reduced by as much as 80% under the Sec. 68 phaseout rules. Other itemized deductions (e.g., medical expenses) that are subject to a threshold based on a percentage of adjusted gross income (AGI) will also be affected. In addition, the dollar may be subject to the Sec. 4980A 15% excise tax on excess accumulations (as defined in Sec. 4980a(d)] and distributions (defined by Sec. 4980A(C)(1)(A) as more than $150,000 per year). The excise tax is deductible under Sec. 2053 in computing the estate tax, but, according to Sec. 691(c)(1)(C), does not generate an itemized deduction.(1)

Example 2: One dollar in a TDV subject to the See. 4980A excise tax passes from decedent Y, whose estate is subject to a 60% tax rate. Z, Y's heir, is in the 39.6% Federal tax bracket; the bequest causes a loss of 80% of his itemized deductions, plus a loss of his medical and casualty loss deductions. All taxes are paid from non-TDV funds. As shown in Table 1, above, the dollar triggers a 15 cent excise tax and a 51 cent estate tax (0.6 ($1.00 - $0.15)). When Z collects the dollar, it is IRD, but will generate an offsetting itemized deduction of 51 cents for the estate tax paid on it.(2) However, the actual deduction is 10.2 cents, due to the 80% phaseout of itemized deductions. In addition, Z's deductions will decrease by an additional 17.5 cents because of the percentage floors for the medical 17.5%) and casualty loss (10%) deductions. Hence, Z's taxable income will be increased by $1.073 and $0.425 in income tax will be incurred. As illustrated in Table 1, I's use of a TDV results in $1 of savings and $1.085 ($0.15 + $0.51 + $0.425) in total taxes.

[TABULAR DATA 1 OMITTED]

Example 3: Y's heir, Q, has no medical or casualty loss deductions, but has sufficient miscellaneous itemized deductions such that the phaseout is 3% of the IRD. The combined estate and excise taxes are 66 cents ($0.51 + $0.15). However, Q's taxable income would be increased by the $1 of IRD; her itemized deductions would increase by the 51 cents of attributable estate taxes and be reduced by 1.5 cents for the itemized deduction phaseout. Thus, the incremental dollar of inherited TDV income would increase Q's taxable income by 50.5 cents (($1.00 - 0.51) ($0.015). As depicted in Table 2, at right, this income increases Q's income tax by $0.2 ($0.505 X 0.396), triggering total taxes of $0.86.

[TABULAR DATA 2 OMITTED]

Can better results (i.e., lower taxes) be achieved? The options include: (1) limited use of TDVs, (2) disposition of TDVs to minimize taxes and (3) pre-mortem planning to eliminate the problem.

Limiting TDV Savings

One obvious solution is to avoid or limit the use of TDVs. This option is probably not reasonable, because the current income tax savings would be lost. In addition, the taxpayer loses a golden opportunity to save for retirement.

As long as there will be sufficient time between the deferral and the eventual withdrawal of the funds (i.e., the accumulation period) for the deferred amount to exceed 115% of the amount that could be accumulated in a currently taxable account, there should be no limit on the amount to invest in a TDV. (In the absence of the excise tax, use of TDVs appears to be worthwhile at all times.) The length of the accumulation period is a function of the rate of investment return and the income tax rate. See Table 3 on page 626.

Table 3: Number of Years for TDV Investment
Subject to 15% Excise Tax to Be Worth
More Than Taxable Investment
(as a Function of Pretax Rate of Return)(a)
Rate of return (%)     4    6   8   10    12   14   16
Years to exceed
breakeven             19   12   9    8     6    6    6
(a) At 39.6% Federal income tax rate.

Disposal of TDV Savings at Death

To avoid the problems discussed above, the decedent can leave TDV funds to his spouse at death, and the surviving spouse can elect under Sec. 4980a(d)(5) for the excise tax to apply on the spouse's withdrawal of such funds or death. This transfer also avoids estate tax (due to the marital deduction) and income tax. This strategy may not be beneficial if the funds would not be subject to excise tax if left in the decedent's estate, but would be in the surviving spouse's estate. If the expected accumulation period of the TDV funds is sufficiently long to exceed the Table 3 breakeven point, the continued deferral makes economic sense.(3) However, on the surviving spouse's death, the problems and solutions discussed herein continue to apply.

Bequeathing TDV assets to one's spouse is very advantageous; why would a married taxpayer choose any other alternative? if, for example, the decedent had children from a prior marriage, he might want TDV assets to go to them. Or, the decedent could have forgotten to change his designation of plan beneficiary or his will residuary clause when he remarried, so that the assets end up with his children or former spouse. Simply by leaving the TDV assets to the surviving spouse, and by funding bequests to other beneficiaries with other assets, any excise tax and the income tax on the TDV balance can be avoided on the decedent's death. This course is particularly advantageous when the second spouse is relatively younger.

Alternatively, the decedent can bequeath the TDV income to a charity at death. This will not avoid the excise tax, but it will avoid the estate tax, due to the charitable deduction, as well as the income tax, because the charity will not be subject to the income tax when it collects the TDV assets. This can also be done during the taxpayer's life, but care must be taken to avoid the charitable contribution deduction limits.

For taxpayers who are not married or do not wish to make large charitable gifts, the issue is the best way to extract funds (presumably at death) from TDVs for the benefit of others.

Mitigating the Tax Problem at Death

As was discussed in Example 2, $1 in a TDV can trigger as much as $1.085 in taxes. This arises in part because the TDV funds trigger the phaseout of the beneficiary's itemized deductions. At death, the excise tax can be avoided by leaving the TDV assets to a surviving spouse. Estate tax can be avoided if the TDV assets are left to a surviving spouse or to a charity. The additional income tax to heirs on TDV assets that is triggered by the phaseout of itemized deductions and loss of AGI-based deductions can be avoided only if such assets are left to heirs who will not incur such phaseouts and/or deduction limits.

Alternatively, the estate could collect the IRD and pay the income tax thereon. However, the estate will be subject a 39.6% rate if its taxable income exceeds $7,650. If all of the heirs are in the 39.6% bracket, there is no cost incurred in having the estate collect the IRD; in fact, there is a slight gain. However, there is a cost if some of the heirs are in lower brackets.

Manipulating which assets the various heirs receive and how they receive them will save the estate and the heirs income tax, but it has no effect on the transfer taxes paid. If the decedent collects the TDV assets shortly before death, he will pay the income tax thereon, not the heirs. This saves up to $0.2376 ($0.396 X 0.6) of transfer tax per dollar of TDV assets, but loses the $0.2020 (0.396 X $0.51) income tax deduction for the related estate tax that the heir would have received. Thus, the net savings is $0.0356 per dollar.(4) This course avoids transfer taxes on the funds the decedent uses to pay the excise tax on the TDV assets. The savings are even higher if the heirs would have been subject to itemized deduction phaseouts, and higher still if the decedent was not subject to the itemized deduction phaseout, but the heirs are. Alternatively, there may be an offsetting cost if the decedent is subject to itemized deduction phaseouts and the heirs are not. As was discussed, all costs related to loss of itemized deductions can be avoided by having the estate recognize the TDV income and take the corresponding itemized deduction for the related estate taxes.

The preceding discussion focused on the marginal effects of a dollar of TDV assets. However, the actual effects on a given estate will not be as great as this analysis portrays, because not all dollars in the estate are subject to the marginal rate. The five alternatives presented in the Comprehensive Example on pages 628-630 illustrate the options available to a 70-year-old person dying in 1995 with a $15 million estate, of which $5 million is in a TDV.

Split-Interest Trusts

Another alternative is to bequeath the TDV assets to a trust with the income to the heirs and the remainder to a charity. Charitable remainder annuity trusts (CRATs] and unitrusts (CRUTs)(5) are exempt from income tax under Sec. 4947(a)(1)(6); thus, the trust is not taxed on the TDV assets it receives. Generally, the estate receives a charitable deduction for the value of the remainder interest on the date of the decedent's death. The trust beneficiaries are taxed on their payments from the trust. CRATs are examined in the Comprehensive Example, Alternatives IV and V.

Use of a CRAT or CRUT appears to be a good way to dispose of TDV assets in cases in which the heirs' welfare is the primary concern, but there is a trade-off of current dollars for future income. In essence, such trusts allow the decedent's tax deferral to continue for the benefit of the heirs for an extended period of time. Such arrangements are very flexible.(7) In a CRAT or CRUT, the term of the interest can be over the life of any person or persons alive at the decedent's death or over a fixed term of up to 20 years. Under Sec. 664(d)(1)(A), the minimum annual distribution under a CRAT is 5% of the fair market value (FMV) of trust assets at the inception of the trust. The maximum annual distribution is the amount that reduces the chance that the charity will receive any assets below 5% of FMV. The exact interpretation of this rule is currently in dispute.8 However, as a general rule, the larger the income interest given to the heirs the better off they are. In a CRUT, under Sec. 664(d)(2)(a), the minimum required annual distribution is 5% of the annual FMV of trust assets on the first day of the trust tax year.

GST Tax Considerations

If the decedent bequeaths TDV assets to a "skip person" (as defined in Sec. 2613(a)(1) and includes e.g., grandchildren), the taxes increase, as does the level of complexity. Why leave TDV assets to a grandchild? Because the parent might have predeceased the grandchild, in which case, according to Sec. 2612(c)(2), generation-skipping transfer (GST) tax does not apply; or, family discord or disability of the child may cause a grandparent to want to leave TDV assets to a grandchild.

Example 5: The facts are the same as in Example 2, except that the GST tax applies to the bequest to Z and transfer taxes are paid from non-TDV assets. Using an analysis similar to that in Table 1, the total tax paid increases from $1.085 to $1.591 (consisting of an excise tax of $0.15, an estate tax of $0.51, a GST tax of $0.55 (deductible under Sec. 691 (c)(3)) and an income tax on the heir of $0.381).

[TABULAR DATA 1 OMITTED]

Example 6: The facts are the same as in Example 5, except that the transfer taxes are to be paid from the TDV assets. The total tax paid drops to $1.196 (made up of an excise tax of $0.15, an estate tax of $0.51, a GST tax of $0.121 and an income tax of $0.415).

Having the GST bear the tax makes a significant improvement in the results, from the family's perspective. However, the transferee loses. Withdrawing the funds from the TDV just before death, while having them bear the associated transfer taxes, improves the results even further.

Example 7: B, who is in the 39,6% Federal tax bracket, withdraws $1 from his TDV just before death. The additional income triggers phaseouts of B's itemized deductions (including medical and casualty losses). The total tax is reduced to $0.904 (excise tax of $0.15, income tax of $0.477, estate tax of $0.224 and GST tax of $0.053). If the incremental income triggered only the 3% phaseout of itemized deductions, and left the medical and casualty loss deductions intact, the total tax would drop to $0.886 (excise tax of $0.15, income tax of $0.408, estate tax of 0.265 and GST tax of $0.063).

Conclusion

From an economic and tax perspective, it is not possible to overuse TDVs unless the funds about to be invested will be subject to excise tax before funds to pay such tax can be earned. If the estate is comprised of both TDV assets and other assets that will not trigger IRD, the TDV assets should be left to the surviving spouse (if one) and/or a charity. If TDV assets are to be left to a beneficiary other than the surviving spouse or a charity, the decedent should consider withdrawing the assets before death, thereby maximizing the amount left to the family after death. Alternatively, the estate generally should recognize the income implicit in TDV assets and pay the income tax thereon before distributing the net amount to the heirs. Another alternative is to bequeath TDV assets to a CRAT or CRUT with the income level and term set to maximize the benefits to heirs. Finally, if TDV funds will be subject to the GST tax, the TDV assets should bear the tax.

(1) With the exception of comments related to the excise tax, the points made in this article apply to most IRD items. Further, the marginal rate analysis presented applies only to taxpayers in the highest income and estate tax brackets; however, the form of the analysis and the conclusions are the same for all taxpayers. (2) In this and all subsequent calculations, the effects of state death taxes have been ignored. Such taxes are frequently offset by the Sec. 2011 credit for state death taxes paid and have no effect on the amount of tax paid at death. However, because the credit reduces the amount of Federal estate tax, it reduces the itemized deduction for estate taxes that the beneficiary of the IRD will receive. Thus, if an estate is subject to state death taxes, the taxes are even higher than as shown in the examples. (3) This discussion ignores the Sec. 2013 credit. (4) There are no savings from early recognition of the TDV income if the excise tax does not apply and no beneficiary would be subject to phaseouts or otherwise--would lose the benefit of deductions. The savings from having the decedent recognize the income equal the estate tax on the amount used to pay the income tax (0.6 X $0.396), while the savings from having the heirs deduct the estate tax on their income tax returns equal their marginal income tax rate (39.6%) multiplied by the estate tax paid on a dollar of TDV assets (60%). This equality breaks down when the excise tax is paid, because it reduces the estate tax paid per dollar of TDV assets but does not generate an income tax deduction for the heir. A similar effect occurs when the recipient of TDV assets has to recognize the income therein and is subject to AGI-based deduction limits. (5) See Gianno, "The Charitable Remainder Unitrust," 26 The Tax Adviser 435 (july 1995). (6) See IRS Letter Rulings 923 7020 (6/12/92) and 9253038 (10/5/92). (7) See Sec. 664(d) and the regulations thereunder. (8) See Rev. Rul. 70-452, 1970-2 CB 199 (charitable deduction not allowed when the probability exceeded 5% that the noncharitable beneficiary would survive the exhaustion of the fund in which the charity had a remainder interest); but see Est. of George H. Moor, TC Memo 1982-299.