THE NEW EXCISE TAX WINDOW:
TAX BONANZA OR TAX TRAP

By Myron S. Blatt, CPA, Lockwood Pension Services, Inc.

IRC section 401 (a) (9) (as amended) requires that minimum distributions be made from retirement plans based upon the life expectancy of the plan participant and his or her beneficiary. All distributions are subject to ordinary income taxes at the applicable rates, and the actual effective tax rates may be higher if itemized deductions and exemptions are reduced or eliminated. State and local taxes may also be imposed with the potential of increasing the total taxes due to approximately 50% of the distribution.

Excise Taxes on Distributions Before The 1996 Changes

In addition to the above income taxes, there may be an excess distribution tax imposed on a portion of the distribution. This excise tax is payable when a distribution is in excess of the statutory threshold, $155,000 for 1996 and $160,000 for 1997 (the threshold is increased for inflation but not necessarily every year depending upon a rounding formula). The rate of tax is 15% of the amount in excess of the statutory threshold. For a distribution of $200,000 in 1996 the tax is $6,750 (200,000 less $155,000 times 15%). If an excise tax grandfather election was made in 1987 or 1988, distributions in excess of the statutory threshold will not be subject to the excise tax if the recovery of the grandfathered amount is accelerated by filing Form 5329 with the individual's tax return. Failure to take out the required minimum amount will trigger an excise tax
of 50% of the amount required to be
withdrawn.

New Excise Tax Abatement Window

The recently enacted Small Business Job Protection Act of 1996 (the act) contains a provision which temporarily suspends the 15% excise tax on excess distributions for distributions made in 1997, 1998, & 1999. During these three years, the 15% excise tax will not be imposed regardless of the size of the distribution. However, the new law does not suspend the application of the 15% excise tax on excess accumulations existing at the taxpayer's death. Another provision of the act allows people who continue to work after age 701Ž2 the option of not having to start taking distributions from "qualified plans" and of stopping distributions if they have already started, until they retire. This rule does not apply to IRAs or to people owning 5% or more of their
businesses.

The question arises as to the types of situations in which an individual would benefit by taking advantage of this three-year moratorium on the excise tax. There is no simple answer to this question and adequate planning is necessary before any decisions are made. Among the factors to be considered are 1) the individual's income tax rate, 2) the existence of losses from flow-through entities, 3) investment allocations, 4) rates of return, 5) the age of the individual, 6) charitable intentions, 7) possible loss of protection of funds from creditors, 8) shifting of assets for estate tax purposes, and 9) personal financial planning needs.

Generally speaking, taxpayers under 591Ž2 should not avail themselves of the moratorium since they would lose 10+ years of tax deferred compounding, and to avoid the 10% early distribution tax, distributions would have to be taken out over at least a five-year period. Since the moratorium would only be in effect for the first three years of the payout, the distributions after the moratorium period (i.e., distributions after December 31, 1999) would be subject to the 15% excess distribution tax.

For those taxpayers in their early 60s there would again be the loss of a substantial tax deferral opportunity. Individuals whose estate plan includes the leaving of their retirement plan to their surviving spouse and then their heirs should also disregard the three year moratorium since the value of tax deferred compounding over two generations more than offsets the excise tax. Moreover, at age 591Ž2 there is always the availability of annual excise tax-free withdrawals of $160,000 adjusted for inflation.

For those in their late 60s, the factors cited above--loss of tax deferral, availability of excise free withdrawals--may still apply. Other factors which may also come into play are the possibility of lower taxes due to retirement and the relocation to a state with lower or no income taxes. However, for very large accumulations where distributions must begin within two or three years, the proper distribution strategy most likely would include accelerated withdrawals in order to take advantage of the excise tax moratorium. Likewise if mandated distributions have already begun and they are subject to the 15% excise tax, it would probably warrant increasing the withdrawals to save excise taxes that would otherwise be payable in the future.

Since there is a three-year window, should you wait until 1999 before taking a distribution or take one every year? This too depends on the individual situation. The total income taxes paid may be higher under one scenario than another. The value of two more years of tax deferral must also be considered. Looking at the income tax factor by itself, if the individual is already in the highest brackets, an accelerated distribution can wait until 1999. Otherwise, it should probably be taken every year.

Finally ill health may be a reason for taking large excise tax-free withdrawals. Even after income taxes and estate taxes, the savings on the excise taxes could be considerable. Remember there is no moratorium on the 15% excise tax which is imposed at death.

Withdrawals vs. Tax Deferment

Exhibits 1 to 3 illustrate the comparable results of withdrawing $1,000,000 from a retirement plan and growing it outside the plan (Exhibit 1) vs. letting the funds earn a tax deferred rate for a period of 20 years and then paying ordinary income taxes and the full 15% excise tax upon withdrawal for taxpayers aged 65 (Exhibit 2) and 70 (Exhibit 3). The exhibits are based upon alternative pretax rates of return of 9%, 12%, and 15% and alternative after tax rates of returns of 6%, 8%, and 10%.

Using the exhibits it can be seen that an individual of any retirement age who withdraws $1,000,000 from a retirement plan and earns 6% after taxes will have $1,266,106 after 14 years. A 65 year old who defers withdrawal of the same amount to age 70 and then makes the required minimum withdrawals will have $1,311,305 after 14 years if his fund earns 9% before taxes. A 70 year old who begins to withdraw $1,000,000 at the required minimum rate, will have $1,225,664 after 14 years at the same 9% pre-tax rate. From the exhibits it can be seen that the benefits of deferral are more valuable at higher pretax rates of return and longer deferral periods. The ultimate excise tax exposure then becomes less significant.

The difference in the rates, tax deferred vs. non-tax deferred, is an assumed Federal and state capital gains rate of 33 1/3%. This rate can be higher if either the loss of itemized deductions and exemptions or
the alternative
minimum tax becomes a factor. An income tax rate of 44% was used for
all withdrawals. In all instances deferring the withdrawal, even at age
70, produces a larger after-tax amount at the end of the
20-year period. However, there is a time at the beginning of the 20 year period when the nondeferred amounts are larger. The value of the deferred amount becomes larger than the non-deferred amount between 8 and 18 years depending on the taxpayer's age and comparative rate of return.

The strategy of leaving the plan to heirs can be the determining factor in taking accelerated distributions or, for that matter, any nonrequired distributions. The 65 year old in Exhibit 2 had accumulated almost $2,000,000 additional funds in his IRA after
10 years and approximately the same amount after 20 years (mandatory distributions having been made) at a 10% appreciation rate. These funds could be passed down to children who, if they took annual withdrawals over 30 years, would receive distributions totaling approximately $13,000,000 using the same 10% growth rate. Even using lower growth rates, with proper planning, retirement vehicles can generate big rewards to heirs. *

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA\PFS

Contributing Editors:
Alan Fogelman, CPA
Clarfield & Company P.C.

David Kahn, CPA\PFS
Goldstein, Golub Kessler & Company, CPAs P.C.

EXHIBIT 1

AFTER TAX GROWTH OF $1 MILLION WITHDRAWAL
($560,000 AFTER TAXES) FOR 20 YEARS

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EXHIBIT 2

$1 MILLION TAX DEFERRED AT AGE 65 AND WITHDRAWN
USING TAX RATE OF 59% ADDING DISTRIBUTIONS IN YEARS 6-20

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EXHIBIT 3

$1 MILLION TAX DEFERRED AT AGE 70 AND WITHDRAWN
USING TAX RATE OF 59%