The Penalty Tax

The penalty tax involved is the excess distributions and accumulations tax imposed under IRC Sec. 4980A, (renumbered from 4981A by the 1988 Technical Correction Act)., which was added by TRA 86. That section imposes a 15% penalty on excess distributions from qualified plans, including Keogh plans and employee stock ownership plans (ESOPs), tax sheltered annuities, and IRAs. It also imposes a 15% estate tax on excess accumulations remaining in such programs at death.

The penalty on excess distributions is an excise tax not eligible for any reduction by tax deductions or credits, and must be paid each year an excess distribution is received. The penalty on excess accumulations is an estate tax which cannot be reduced or eliminated by the marital deduction, the unified credit, or the charitable bequest deduction.

Because the penalty tax is in addition to other taxes imposed on the qualified plan benefits, the effect is to drive the income tax rate on excess distributions to 43% at the federal level (assuming the base income tax rate on such distribution is 28%), and to increase the total taxes imposed at death on excess accumulations to as much as 80% or more.

The 80% rate results from the fact that these benefits constitute income in respect of a decedent, subject to both estate and income taxation. Assuming a 50% estate tax, and a 28% income tax on the balance, the combined income and estate tax bracket applicable to income in respect of a decedent is 64%. Add the 15% additional estate tax, and the total tax rate approaches 80%, without factoring in state or local taxes. If, as is anticipated by many tax professionals, the income tax rate increases, the effective tax rate on the accumulations will be even higher. And in larger estates, where the maximum estate tax rate is 55% (60% on assets between $10 million and $20 million), the diminishment can approach 90%. The additional 15% tax can be avoided, at least in part, but only if action is taken now.

Avoiding the Penalty

Sec. 4981A(c)(5) provides a special rule which permits an individual to avoid the 15% penalty to the extent of benefit values as of August 1, 1986 that were held in qualified plans, including Keogh plans and ESOPs, tax sheltered annuities, and IRAs. To be eligible to elect to have the special rule apply, the individual must have accumulated at least $562,500 in such programs as of August 1, 1986, and must make an election to be filed with his or her 1988 income tax return. The election is made on Form 5329.

The election cannot be made until three things are determined:

1. Whether in the context of the individual's financial and estate planning needs, the election should be made.

2. The amount as to which the election is available.

3. The manner in which the protection afforded by the election is to be utilized.

Should the Election be Made?

Whether the election should be made must be determined in the context of the individual's financial and estate planning goals. The election will protect the dollar value of benefits accumulated under tax sheltered retirement programs from the 15% penalty tax, but at a price. That price involves a difference in measurement of the excess distributions and accumulations.

Lifetime Considerations

For anyone who does not make the election, or who is ineligible to make the election because August 1, 1986 benefit values were $562,500 or below, distributions of up to $150,000 in any year will not trigger the excess distributions tax. The penalty tax will only be imposed on amounts distributed in excess of the $150,000 threshold. The $150,000 threshold will increase when $112,500, indexed for inflation after 1987, is higher than the $150,000 floor.

If the election is made, the $150,000 floor is unavailable and the threshold becomes $112,500 indexed for inflation after 1987. For 1988, this amount is $117,529. Depending on the method of utilizing the grandfather election, the election can cause more of each annual distribution to be subject to the 15% excise tax than would otherwise be the case.

If the election is not made, the amount which can be withdrawn as a lump sum distribution without the 15% excise tax is five times the threshold amount, or $750,000. If the election is made, the threshold amount is reduced to $112,500 indexed for post-1987 inflation, and the lump sum which can be distributed without the penalty is five times the lower amount.

Financial planning includes a projection of the income needs of the individual, and the source of the income to provide for those needs. If amounts held in tax sheltered retirement programs are likely to be used to satisfy income needs, then the amounts likely to be withdrawn, the availability of other assets, and similar issues must be reviewed to determine the desirability of the election.

Estate Considerations

The excess accumulations tax is imposed on death benefits accumulated in tax sheltered retirement programs. The tax is an estate tax, and is equal to 15% of the amount by which benefits payable at death exceed a threshold amount. The threshold amount is the lump sum necessary to provide a life annuity of the annual amount which could be withdrawn without penalty in the year of death, measured by the life expectancy of the individual immediately prior to death.

Certain amounts are not included as benefits payable at death for purposes of the excess accumulations tax. The proceeds of a life insurance policy held under the plan, to the extent they exceed the cash value of the policy, are not included. This gives the insured death benefit a significant tax advantage over other death benefit payments from a qualified plan, since the life insurance element is not subject to either income taxes or the excess accumulations tax. Any basis the decedent had in the benefits under the programs is also not considered a benefit payable at death for purposes of the excess accumulations tax. This would include previously taxed amounts, such as employee contributions, previously taxed loan amounts, and PS58 amounts attributable to life insurance premiums.

Death Threshold Amounts

As with lifetime distributions, the threshold amount is measured differently depending on whether the election is made. If no election is made, the annual withdrawal permitted is set at a floor of $150,000. The lump sum necessary to provide a life annuity of that amount for an individual age 65 is slightly more than $1,000,000; for an individual age 70, the amount is approximately $900,000. Table I shows the threshold amounts, based on an annuity of $150,000 per year, applicable to deaths occurring at various ages. This table will apply to those who die without making the election, until post-1987 inflation causes $112,500 to increase above $150,000.

If the election is made, and the annual withdrawal amount is reduced to $112,500 indexed for post-1987 inflation, the amount of death benefit protected from the 15% estate tax is reduced. Of course, as is described later, if the unused grandfathered amount exceeds the reduced threshold, the unused grandfathered amount is the amount protected from the penalty. For example, assume the threshold amount for an individual dying at age 70 if the grandfather election is made is $800,000. Assume further that the unused grandfather amount is $900,000. The greater of the two amounts, $900,000, is the amount protected from the penalty.

Special Problems of Excess Accumulation at Death

The excess accumulations penalty is not eligible for the marital deduction, the unified credit, or the charitable bequest deduction. As a result, the penalty tax must be paid even if the estate is otherwise exempt from estate taxes. If the qualified plan, tax sheltered annuity, or IRA accumulations are used to pay the penalty tax, the amounts withdrawn will be subject to income tax. The income tax increases the cost of accessing the amounts necessary to pay the penalty.

For example, if the excess accumulations penalty is $72,000, money in the tax deferred retirement program is used to pay the penalty, and the income tax rate is 28%, then a total of $100,000 will have to be withdrawn. The cost of using the retirement program money to pay the penalty tax is increased by $28,000 or 40% of the penalty amount.

In addition, if the retirement accumulations are payable to a surviving spouse and would otherwise be eligible for the marital deduction, then the accumulations, to the extent they are used to pay the penalty tax, are includable in the estate of the decedent and subject to estate taxes. This is a result of the rule which denies the marital deduction to amounts used to pay estate taxes.

The Spousal Rollover

In most instances, a surviving spouse is entitled to rollover amounts distributed from qualified plans into his or her own IRA, which defers both the income tax and the estate tax. The temporary regulations indicate that a rollover to an IRA to which no other monies have been contributed will prevent the rollover account from inclusion as a benefit payable at death for purposes of the excess accumulations tax on the surviving spouse's death. However, if the surviving spouse deposits death benefits to an IRA which contains the spouse's own contributions, the death benefits will be included for purposes of the excess accumulations tax in the spouse's estate. This is true even though the amounts were already subject to the excess accumulations tax in the estate of the participant.

In other words, on the death of the first spouse, excess accumulations are subject to the 15% penalty. If the surviving spouse rolls the excess accumulations into an IRA to which the surviving spouse has made contributions, the rollover is included as part of the benefits payable at the death of the spouse and to the extent the total exceeds the spouse's threshold amount at death, could be subject to the 15% excise tax a second time.

Clearly, a surviving spouse should rollover death benefits received on the death of the first spouse to an IRA to which the surviving spouse has made no contributions. This will prevent a second penalty tax on the accumulations.

The 1988 tax law changes give the surviving spouse the opportunity to avoid the excess accumulations penalty on the first death. The surviving spouse can, if the corrections become law, elect to exclude death benefits from tax sheltered retirement programs from the excess accumulations penalty. The election converts the death benefit to benefits accumulated for the surviving spouse. Such amounts will be subject to the excess distributions tax if the spouse withdraws too much in any year, and to the excess accumulations tax if the benefits payable at the death of the surviving spouse exceed the applicable threshold amount.

The Election Decision

No decision can be made as to whether the election is desirable without at least a cursory review of the assets and estate plan of the individual. If the tax sheltered retirement savings are the primary liquid asset of the estate, subjecting such assets to the penalty could jeopardize the security of other assets. If the savings are to remain in the tax sheltered environment for a significant time after the death of the individual, provision must be made for any penalty.

If the withdrawals during lifetime will leave less than the threshold amount applicable if no election is made as death accumulations, and if lifetime withdrawals are not likely to exceed $150,000 per year, the election may not be necessary. If the amount as to which the grandfather election is available is so large it is likely to exceed any otherwise applicable threshold amount, the election should be made.

These and related considerations can be made only with a proper review of the estate plan of the individual, and should be made prior to any decision on the grandfather election.

Determining the Amount Eligible for the Election

The grandfather election is available as to the amounts accumulated as of August 1, 1986, in qualified plans, including Keogh plans and ESOPs, tax sheltered annuities, and IRAs. Hidden within the governing regulations, however, is the procedure for verifying the benefit values as of that date, which involves substantial time and effort to follow successfully.

The grandfather election is made on Form 5329, labelled as the "Return for Individual Retirement Arrangement and Qualified Retirement Plan Taxes." The 1987 version of the form, under the heading "Other Information," contains the following:

"2. Do you elect the special grandfather rule under

Regulations section 54.4981A-1T to exempt from tax the

portion of distributions treated as a recovery of benefits

accrued on or before August 1, 1986? (See Part IV of the

instructions).

"If `Yes,' enter: (a) your initial grandfather amount > $

; and (b) check the grandfather

recovery method you are electing:

"/--/ Discretionary method /--/ Attained age method"

The instructions for Form 5329, under Part IV, provide the following direction:

"See Regulations section 54.4981A-1T for an explanation

of when to make the special grandfather election, how

to determine your initial grandfather amount, the two

grandfather recovery methods, and recordkeeping requirements."

(Emphasis added)

In the preamble to the regulations cited in the 5329 instructions, the IRS states:

"The calculation of benefits as of August 1, 1986 is done

by plan administrators or trustees who hold benefits

under these plans or IRAs."

Later in the Regulations, under the heading "Reporting Recordkeeping and Elections," The following appears:

"The individual may not independently determine the

value of the grandfather amount, as the grandfather

amount may only be substantiated by records furnished

the individual under the plans or IRAs for which the

individual is claiming a grandfather amount."

In effect, the determination of the value of benefits as of August 1, 1986 can only be made by the plan administrator, trustee or custodian of the plan, annuity or IRA as of that date, and must be in written form in the hands of the individual at the time the election is made.

Locating the Records

The problems are obvious. Most IRA trustees and custodians do not provide monthly reports as to benefit values. Unless a report as of August 1, 1986 was prepared and retained by the individual, a new report must be obtained. Data necessary to produce such a report is not in a form easily retrieved by most trustees and custodians, and there will be time and expense in obtaining the information. In some cases, the information is maintained on microfilm and a charge is imposed on the person requesting the data. In some cases, the bank has merged with another institution and the records are difficult to locate. As a result of the stock market crash in 1987, many smaller brokerage houses have ceased to exist, and record retrieval is extremely difficult.

Many will have rolled benefits from one plan to another from a plan to an IRA, or from one IRA to another, and will not be holding benefits with the trustee or custodian used in 1986. Obtaining information from a bank or brokerage house with whom one is no longer doing business is frequently difficult, especially if the individuals dealt with at the time are no longer employed by the firm. Many were participants in plans terminated after 1986 and no longer in existence. In such cases, the plan administrator will have to be located and the substantiation obtained.

The value of benefits under a defined benefit plan must be actuarially determined and based on valuation assumptions used by the plan in 1986. An actuary must be retained for this purpose and sufficient data made available to permit the determination to be made.

All of these steps must be taken in time to permit the election to be filed with the 1988 income tax return; these steps require actions well in advance of the filing deadline. All of these steps must be communicated to affected individuals, and the person who will be held responsible, rightly or wrongly, by those unable to obtain the information in time is the accountant.

Administrator, Trustee, and Custodian Responsibilities

The regulations provide that the administrator, trustee, or custodian has to supply the required substantiation if requested to do so before April 15, 1989. The request must be received by that date, and if received in time the administrator, trustee, or custodian must provide the required information by July 15, 1989. Most individuals are required to file tax returns by April 15, but can obtain an automatic extension to August 15. If the information is obtained at the last minute, this will leave only one month to make the necessary decision.

Information Required

Because the sheer volume of requests is likely to cause delays and data problems, requests should be made immediately to allow adequate time to the administrators, trustees, or custodian. Because the regulations offer an alternative valuation method, which could prove advantageous to many individuals, the information requested should include the following:

. Value of benefits as of August 1, 1986.

. Value of benefits as of the valuation date immediately preceding August 1, 1986.

Value of benefits as of the valuation date immediately following August 1, 1986.

If a valuation was not performed as of August 1, 1986 (and most qualified plans would not have a valuation on that date) the individual can prorate the change in value of his or her benefit between the valuation date immediately before August 1, 1986 and the valuation date immediately following August 1, 1986. In many plans, including defined benefit plans, this will result in a larger grandfathered amount.

If, for example, the plan's investment experience was such that values increased more rapidly after August 1, 1986 than before that date, the proration will capture more of the investment experience as of August 1, 1986. If the accrued benefit in a defined benefit plan increases as of a birthday, and the birthday occurs after August 1 but before the valuation date, the proration will include part of the accrued benefit increase.

To properly make the grandfather election, the information must be obtained, and should be obtained without delay to permit appropriate determinations as to the grandfather amount.

Method of Utilizing the Election

Form 5329 requires the selection of the manner in which the grandfathered amount will be recognized to be selected at the time the election is made. The regulations describe two ways of measuring how much of each distribution is part of the grandfathered amount; they are called recovery methods.

The first treats 10% of each dollar withdrawn from tax-sheltered programs as a recovery of the grandfathered amount. An individual would have the right to accelerate the recovery to 100% of each dollar, but once that election is made the percentage cannot be reduced. Most individuals will elect the 10% method, which is called the discretionary method on the form.

The second method permitted is called the attained age method, and involves multiplying aggregate distributions for a calendar year by a fraction, the numerator of which is the number of months the individual was over age 35 on August 1, 1986, and the denominator of which is the number of months as of December 31 of the year of distribution the individual was over age 35. No one who was not age 35 on August 1, 1986 can elect the attained age method.

The attained age method is of most value to younger individuals with substantial grandfathered amounts. In most instances, the discretionary method, which permits acceleration to fully protect the first dollars withdrawn, will be preferable.

Conclusion The grandfather election protecting benefits under tax sheltered retirement programs from the 15% excise and estate taxes must be made on the 1988 income tax return. The election cannot be made without a determination that the election fits within the financial and estate planning needs of the individual. The election cannot be made without written substantiation from the administrator, trustee, or custodian of each program involved. The election cannot be made without a decision as to the recovery method.

The preliminary steps require time and an understanding of the issues involved. Failure to take the steps could expose the individuals involved to unnecessary taxation on benefits held in pension, profit sharing, money purchase, target benefit, employee stock ownership and Keogh plans, and on amounts accumulated in tax sheltered annuities and IRAs. ()See also: "The Effect of New Excess Distribution Tax and Excess Accumulation Tax on Estate Planning" by Nadine Gordon Lee, The CPA Journal, June 1988, page 103.