Watch out for that tree!

By Stephen D. Lassar and Mark W. McGorry

In Brief

Planning for Qualified Plans and IRAs

Assets in qualified pension, profit sharing, and 401(k) plans, as well as IRAs, are referred to as "income in respect respect of a decedent" (IRD) items. They are subject to both estate and income taxes that can lead to a dramatic shrinkage in estates.

While IRAs are more flexible to work with than qualified plans, planning can be done with both. Multiple accounts, qualified disclaimers, the generation skipping transfer tax exemption, and trustee discretion can be used in planning for an IRA. Lump-sum distributions from qualified plans can be rolled over into IRAs to achieve similar results.

Distributions of an employer's stock from a qualified plan provide a number of tax savings opportunities.

Those who take early retirement often face unique problems. Some of these can be solved through the use of rollover IRAs and the purchase of annuity contracts.

While IRD assets can create a liquidity problem for an estate, they can be used to fund the purchase of life insurance that can provide the necessary funds.

Qualified pension, profit-sharing, and 401(k) plans are the most tax efficient and flexible way to reduce current business and personal taxes. Combined with various IRA rollover options available to a participant and his or her surviving spouse, they offer the best tax deferral available.

Unfortunately, quite the opposite is true when you view these plans from the point of view of inheriting generations. Assets in these plans are referred to as "income in respect of a decedent" (IRD) items. IRD items are includable in the taxable estate of the last to die of the participant or spouse, if the spouse has been named as beneficiary. They are subject to income taxes in the hands of the beneficiary, after allowing for a deduction for the estate tax associated with this IRD. There is also an additional 15% excise tax on amounts in excess of certain threshold amounts. The result is usually a shrinkage of 80% or more for people with total estates of a few million
or more. With some, total potential taxes exceed 90% of
account value.

However, even with these issues, the qualified plan and IRA still provide the best vehicles for tax planning during the combined lifetimes of participant and spouse. What needs to be done is to find ways to leverage these benefits to the advantage of the next generation(s).

Qualified Plans vs. IRAs

Qualified plans are those sponsored by an employer, such as a corporation, partnership, sole proprietor, limited liability company or partnership, or, in some cases, a nonprofit organization. For a plan to maintain its qualified status, it must contain many restrictions not found in IRAs. As a result, IRAs are much more flexible to deal with from a planning perspective. On the other hand, qualified plans offer an opportunity in funding life insurance policy purchases not available in IRAs. Also in many jurisdictions outside New York State, qualified plans still provide significantly greater creditor protection to the participant than can be found with IRAs.

From a planning perspective, the key differences can be summed up as follows:

* There is much greater flexibility with an IRA. Accountholders can break up the account into multiple accounts and deal with each in different ways. They can handle the distributions during life, as well the beneficiary arrangements for each separate IRA account differently. They can also invest each account as they wish, choosing the custodian, investment advisors, and the investments themselves from a wider variety of choices than would usually be available in a qualified plan.

* Qualified plans tend to be much less flexible for purposes of investment, financial, and estate planning. As a general rule, distributions during lifetime from a particular plan must follow a single method. Sometimes, for multiple plans, a sponsoring employer will require that all plans of a generic category be handled the same way. For example, the employer may require that if an employee wishes to take a lump-sum distribution from one type of defined-contribution plan, he or she must do the same thing at the same time with all plans of that type. To take a lump-sum distribution from an ESOP, the employee would also have to take a distribution from his or her 401(k) and discretionary profit-sharing plan. However, there could still be some flexibility available if the employee were not required to take a distribution from a money purchase or defined-benefit pension plan at that time.

Planning with IRAs

Multiple Accounts. For example, a taxpayer could have three IRAs, one that lists grandchildren as beneficiaries to provide for the longest possible payout and therefore the longest deferral of income taxes. A second account for the taxpayer might list adult children as beneficiaries. They could then take only the minimum required distributions or more, at their option, during their own working years while deferring tax and building account values for their own retirement years. These extra assets can provide financial security for children, which can allow them the freedom to be more generous in their own planning.

A third account could name a charitable remainder trust (CRT) as beneficiary. Children could be the beneficiaries of that trust and receive income for the rest of their lives. This would reduce the amount of estate tax at the accountholder's death because there would be a deduction allowed against the taxable estate for the value of the remainder portion that would eventually pass to charity. The charitable beneficiary could even be a family sponsored foundation over which the family could exercise the ultimate control in selecting the charitable organizations to receive these assets.

If these beneficiary designations were done immediately prior to or anytime after the accountholder had reached his or her "required beginning date," special attention would need to be paid to the effect of designating a charitable trust as beneficiary. Because a charitable trust does not qualify as a "designated beneficiary," the required minimum annual distribution payable during the IRA accountholder's lifetime would be based only on the life expectancy of that individual. As result, the CRT beneficiary designation would make the required minimum annual distributions greater than when the payout was based on the life expectancy of two people. This acceleration of distributions would require greater taxes be paid earlier, perhaps even resulting in payment of the 15% excise tax on lifetime distributions, if any.

Qualified Disclaimers. An alternative approach would involve the use of "qualified disclaimers" in planning. Rather than name the charitable trust as the primary beneficiary, it could be named as the contingent beneficiary. At the death of the account holder, family members who were named as primary beneficiaries could disclaim their beneficial interest so that it would then pass directly into the income tax exempt charitable remainder trust.

Even after the required beginning date, changing the contingent beneficiary should have no negative impact on the required minimum distribution for the participant, as only changes in the primary designated beneficiary can speed up the required minimum rate of payments during the participant's life.

If the designated beneficiary elects to disclaim his or her interest in these IRD accounts, the CRT will become the beneficiary. These IRA assets will then pass after death as a lump-sum into the CRT. (This strategy can also work for many qualified plans.) The CRT will have its own income beneficiaries, which can include the participant's spouse, and/or children, and/or grandchildren, as well as other beneficiaries.

Generation Skipping Transfer Tax Exemption. The $1,000,000 "generation skipping transfer tax" exemption available to each taxpayer can be applied to this transfer. This type of beneficiary arrangement allows the income from these IRD assets to be distributed on a "sprinkling basis" to multiple generations in a way not possible under a direct IRA or qualified plan beneficiary arrangement. The reason is that where there is a noncharitable trust as beneficiary, the distributions during the life of the participant and after his or her death are measured by the age of the oldest beneficiary under the trust. Therefore, it is not possible to have a situation where, after the death of the participant, the children receive income for the balance of their lives followed by a continuation of the income for the balance of the lives of their children (the participants' grandchildren). But, when the distribution is first paid at the participant's death into the CRT, it is no longer limited by the rules associated with IRA and qualified plan distributions under IRC section 401(a)(9). This allows the participant's family to have the growth of these assets over several generations with the result the income tax on those assets is spread out over multiple generations.

Trustee Discretion It is also possible to give the CRT trustee the discretion to choose among the class of beneficiaries to receive the income from the CRT.

One of the interesting aspects to this beneficiary approach is that the final decision to use the CRT technique can be delayed until after the death of the participant. This would occur because the CRT would only be the contingent beneficiary of these IRD assets, because, as noted above, to name it as a primary beneficiary would accelerate the payout during the participant's lifetime. Therefore, the children would be the ones making the decision after the participant's death as to whom and how these benefits would flow. They could elect an immediate lump-sum distribution, which is fully subject to immediate income taxation, or, they could elect to have the payout continue over their lifetimes, subject to income taxes as received. They could also make a qualified disclaimer and allow the IRD assets to pass to the CRT as outlined above. This flexibility allows them to make this decision in light of all of the financial, family, and tax factors that exist at the time of the participant's death.

Planning with Qualified Plans

Beneficiary arrangements under a qualified plan are not as flexible to work with as an IRA. If the participant is in a large plan (e.g., one sponsored by a public company), that plan might provide a very limited choice of payout options to participants and beneficiaries. For example, many defined benefit plans do not provide for a lump sum, either for the participant at retirement or a beneficiary at the death of a participant. As a result, the participant is forced to choose at the time they retire both a beneficiary and the portion of the monthly benefits the beneficiary will receive after the death of the participant. Unfortunately, once the participant initially makes that choice, he or she usually cannot change it at a future date because the benefit amount is fixed based on the age of the beneficiary. This severely limits the financial and estate planning opportunities.

In these kind of situations, it is important not to view the pension as an isolated asset. Rather, it needs to be viewed as simply one part of the taxpayer's overall financial, retirement, and estate planning picture. Because this type of forced annuity payout does provide a basic income flow to the participant and his or her surviving spouse, they might then be more inclined toward making greater use of the annual gift tax exclusions as well as using the unified credit during life or, on a testamentary basis to benefit the younger generations, rather than simply leaving everything to the surviving spouse.

Very often, there is also some form of qualified defined contribution type of plan for the benefit of the participant. Usually these benefits can be taken in a lump-sum distribution by the participant themselves or by the beneficiary at the participant's death. If the participant can take a distribution during lifetime, this can open up a number of planning opportunities. For example, if the participant rolled the distribution, in part or totally, into an IRA, all the planning opportunities for stretching out the benefit payments and taxes as outlined for IRAs would be available.

Distribution of Employer Stock from A Qualified Plan

If the employer plan includes employer stock that has appreciated significantly in value since it was contributed, other planning opportunities become available. Basically, the rules provide that if a participant receives a distribution of employer stock and does not roll it over into an IRA, the amount currently includable in taxable income is only the original cost of the stock at the time the contribution was made to the participant's account in the plan. All appreciation since the time of the contribution is deferred until the stock is sold. At that time the tax is at the capital gains rate. Moreover, these assets are now "step-up in basis" type assets, which would mean that if the participant died while still owning the stock, the capital gain would escape income taxation. Although it would be includable in the taxable estate of the participant, it escapes both ordinary income tax and excise tax on the appreciation in stock value not only during the time the stock was held in the plan, but also on appreciation between the time of distribution and death. This would seem to make this asset an excellent candidate to pass on a testamentary basis to either a younger generation directly or through a credit shelter type trust. The determination of whether to use the direct or trust arrangement of passing this stock would depend on many factors, including whether there is a surviving spouse, the surviving spouse has a need for access to this asset, the size of the overall estate, and the amount of unified credit still available to the
participant.

Another advantage to the participant of having employer stock outside of the plan occurs if the stock is held in a brokerage account. This allows the participant to access cash through a margin arrangement with the brokerage firm. There would be no current income tax associated with this loan and some or all of the interest could be deductible as investment interest. This arrangement can be particularly helpful immediately following retirement when the participant might be incurring some unusually high short-term demands for cash. One common example is where the participant is in transition between a permanent residence and a retirement residence and he or she might be carrying a construction loan or two homes for a period of time.

There are still other planning opportunities with appreciated employer stock received from a qualified plan distribution that the participant could take advantage of during their lifetime. At some later date, if the participant wanted to sell the stock, he or she might be reluctant to do so because of the capital gains tax that would be incurred. The participant could consider first contributing this appreciated stock to a CRT, retaining an income interest for him- or herself, his or her spouse, and possibly, his or her children and grandchildren. Then the CRT could sell the appreciated employer stock all at once or gradually over time, reinvesting the sales proceeds to provide greater diversification and income to the participant and his or her family. Because the CRT is a tax exempt trust, there is no capital gains tax. Instead, the distributions from the CRT will be subject to tax as they are received under the four-tier tax scenario that applies to these types of entities and their beneficiaries. In addition to not having their assets diminished by capital gains taxes, they will also enjoy a current charitable income tax benefit when the CRT is created for the remainder interest that will eventually pass to charity.

Early Retirement

Many plan participants are being offered an early retirement window while in their late 50s or early 60s. Often, these individuals are not ready to retire from the workforce for many reasons including financial necessity, a desire to capitalize on the skills developed over a lifetime by consulting in their field, or simply having little interest in leaving the action associated with working. However, for many of them this would be their first foray into the job market or the entrepreneurial world in many years. As a result, they often do not mind accepting a monthly defined-benefit pension check because it gives them peace of mind. They also take comfort in knowing that some portion or all of this pension benefit will continue if their spouse survives them under a joint and survivor benefit option.

However, many of these people find themselves back in the workforce shortly after severing their employment. They often work as consultants either for their former employer or for others in the same or related field. Those who make the successful jump to a new source of earned income often find they cannot turn off the flow of now unneeded taxable pension income once it has started. Moreover, many find that after a few more years of earning additional consulting income they have unanticipated accumulated additional assets. If they were able to, they would change their pension beneficiary from the surviving spouse to their children or even grandchildren. But they are blocked from doing so because of the inflexibility of their retirement plan's benefit options.

Rollover IRAs. However, if there is an option to take a lump-sum distribution followed by a rollover into an IRA, other options are available. For example, they could simply take IRA withdrawals when and as needed. Their IRA rollover money could be invested, employing long-term asset allocation strategies. If they found they needed to dip into the rollover IRA, they could handle that in one of two ways.

They could keep a small portion of the IRA in an investment that tends to have a very stable price and is easily liquidated without high charges. They could liquidate this portion of their rollover IRA over a period of time, drawing down from both earnings and principal as needed. The balance of their rollover IRA would be left to grow for the longer term.

Alternatively, assuming that they want their accounts to be fully invested along the lines of their long-term asset allocation strategies, as withdrawals are needed they could draw a fixed dollar amount on a pro-rata basis across all investment categories each month. This will have the benefits associated with dollar cost averaging. That is, over time they will not be selling their investment assets at either the high or the low of the equity and bond markets. Rather, liquidations will be at the average price over the liquidation period. Except in very unusual market times, this should mollify the effect withdrawals will have on the overall long-term performance of their investments.

Annuity Contracts. Another way to handle an anticipated gap between income and personal expenses is by employing commercial annuity contracts available from licensed life insurance companies. Annuities with payments that extend over at least five years have a portion of each payment treated as a tax-free return of capital. Therefore, an annuity with payments over a fixed period of time will be largely tax-free to the recipient. For example, a 60-month fixed annuity available today would be comprised of approximately 85% tax-free return of capital and 15% includable in taxable income.

Moreover, since this annuity payout is based on a certain period, without any form of life contingency, this technique can work well for any age retiree. Even if there is a 10% penalty tax for receiving annuity distributions by someone younger than 591Ž2, it only applies to the taxable portion. In our example above, because only 15% is taxable, the penalty tax would only be 11Ž2% of the total payments received. Other non-IRD moneys could be invested in a series of other nonqualified fixed and/or variable annuities. At a later time, as additional income is needed, these can be annuitized or simply be withdrawn as desired. The tax minimization benefit of this annuitization technique only works with annuities purchased with assets outside an
IRA or qualified plan. Even clients
who don't have a lot of personal
cash available could consider funding such a purchase through a home
equity type loan.

Need for Liquid Assets to
Pay Estate Taxes at Death

All the strategies discussed above are designed to preserve income tax free growth of assets for as long as possible. The ultimate result of delaying the payment of income taxes is to substantially increase the income future generations will receive. To successfully carry this out these strategies, however, there must be sufficient liquid assets available to the estate or the beneficiaries to pay the estate taxes associated with these IRD assets within nine months of the death of the participant.

Life Insurance. The traditional benefits for using life insurance to provide estate tax liquidity include the income tax free aspect of the death benefit under IRC section 101(a) as well as the relative ease with which policies can be owned outside the taxable estates of the insureds, usually through an irrevocable life insurance trust.

Since IRD assets are the source of the problem we are trying to solve, we often look to them as a source of cash to fund the purchase of life insurance. One of the simplest and most straightforward approaches is for the participant to take distributions each year in excess of that needed for living purposes. After paying income tax, the net is used to fund gifts to an irrevocable life insurance trust (ILIT), either using the annual gift tax exclusion in conjunction with Crummey provisions or by allocating part of the lifetime unified credit. Often, where the spouse is the IRD beneficiary, survivorship life is used rather than just insurance on the life of the participant alone. This will reduce the annual premium per thousand of coverage by approximately 30% with the concurrent benefit of a reduced gift each year.

Under another approach, the survivorship insurance is sometimes purchased on a pre-tax basis, usually within the directed account of a profit-sharing plan of which one of the insured spouses is a participant. Sometimes a profit-sharing plan is established by a retiree to shelter some of the income from his or her new consulting business. Such a profit-sharing plan could receive a rollover from the participant's conduit rollover that holds the distributions from prior employer(s) plan(s). This can only be done if that conduit-IRA was never commingled with the participant's contributory IRA (that is, the $2,000 per year type).

When there is a small business in which the primary participants in a defined-benefit plan are now and expected to be only family members, it can be advantageous to provide a death benefit from the plan that will be funded solely with insurance on the life of the participants. As a result, any assets that have accumulated in the defined-benefit plan to fund the now deceased participant's retirement will be available to provide pension benefits to other participants. Presumably this would include family members who are bona fide employees entitled to these benefits. Another advantage to this arrangement is that the life insurance death benefit in excess of the cash value will generally be income tax free to the beneficiaries. This technique is now more viable than ever due to the repeal of the family aggregation rules for plan years beginning after December 31, 1996. This change took away the discrimination against family members who work in the same family owned
business.

One other place to use these dollars during the lifetime of the participant is to provide funding for cross-purchase type buyout arrangements. Under this type of scenario, one participant/owner's directed profit-sharing account purchases life insurance on the life of a co-owner/shareholder in whose life the first has an
insurable interest. This allows them
to use pre-tax dollars to fund a life
insurance policy to provide liquidity
at death.

In each of these situations, there is a current economic benefit to the plan participants. As a result, they will recognize taxable income currently, not for the full premium paid, but rather, based on the term type charges used for measuring the taxable amount. These are commonly referred to as the PS-58 rates for policies on a single life and the US-38 rates applicable in survivorship life situations. They are generally a small fraction of the actual premium, except at advanced ages (approximately age 80 and older). *

Stephen D. Lassar, JD, LLM, CPA,
is Senior Director of Taxation with Saltzer Lassar Piccinnini & Company LLC. Mark W. McGorry, JD, MSFS, CPC, CLU, ChFC, AEP, is with Braunstein, McGorry & Company LLC, an insurance and investment firm offering securities through Nathan and Lewis Securities, Inc.