AN EXAMPLE IDENTIFIES THE

PROBLEMS

To illustrate the impact of excise, income, and estate taxes at the death of a qualified plan owner, consider the case of an individual, age 64, who is single retirement plan with a balance of $2 million to which he contributes $30,000 annually and which earns a return of 8% before- tax. Assume he contributes $30,000 at the beginning of the plan year and dies at the end of such year. If marginal income and estate tax rates are 31% and 55%, respectively, the taxes paid relative to this individual's last $30,000 contribution plus the $2,400 it would have earned in the last year would be:

Excisetax(15%of$32,400)$4,860

Estatetax(55%of$27,540)15,147

Incometax(tobeneficiaries)

(31%of$17,253)5,348

Totaltaxespaid$25,355

Therefore, theplan beneficiaries would realize only $7,045 from the last contribution. Clearly this is an undersirable result, caused by lack of foresight and consideration of future tax consequences. At a minimum, excise and estate taxes can be reduced, resulting in substantial savings.

RULES OF SEC. 4980A

Sec. 4980A was added by TRA 86 to limit tax-deferred build-up of retirement plans in excess of an amount required to adequately provide for retirement. By enacting this section, Congress sought to limit the ability of taxpayers to accumulate "excess" retirement benefits through multiple retirement plans, e.g., maintenance of plans through more than one company or use of IRAs in combination with other qualified plans. The Sec. 4980A excise tax is generally effective for distributions and accumulations occurring after 1986.

The 15% excise tax under Sec. 4980A applies to lifetime distributions from a qualified retirement plan (1) in excess of the greater of 1) $112,500 (2) indexed for inflation, or 2) $150,000, defined as the base amount. If a lump-sum distribution is received from a retirement plan, the plan owner may use a 5-year averaging method to compute the tax. Distributions as defined in Sec. 4980A do not include distributions made after an individual's death, distributions rolled over into a separate retirement plan, and distributions from a Sec. 72(f) annuity contract, among others. In addition, if the spouse of an individual is the sole beneficiary of the plan asstes, he or she may elect to defer the application of Sec. 4980A. (3)

Example 1. To illustrate calculation of the excise tax on excess withdrawals, assume a qualified plan owner makes a withdrawal of $350,000 during 1991. The excise tax imposed thereon would be:

Annualwithdrawal$350,000

Less:Baseamount(150,000)

Excesswithdrawal200,000

Excisetaxrate15%

Excisetax$30,000

The Sec. 4980A excise tax also applies to excess plan accumulations at death. This excess amount is defined as the date of death value of the accumulated plan assets in all qualified employer plans and IRAs in excess of the present value of a single life annuity with annual payments equal to the base amount. This present value is calculated using 120% of the federal mid-term rate applicable for the month of valuation and mortality estimates, based on age of the taxpayer at death.

Example 2. To illustrate determination of the excise tax on excess accumulations, assume an unmarried individual, age 50, dies with accumulated plan assets of $2 million. Using a federal mid-term rate of 9.6%, the appropriate annuity factor for an individual age 50 is 8.9655. Therefore, this individual would be subject to the excise tax since accumulated plan assets at the date of death exceed $1,344,825 $150,000 x 8.9655. The excise tax on the excess accumulations would be:

Accumulatedplanassets$2,000,000

Less:Baseamount

(8.9655x$150,000)(1,344,825)

Excessretirement

accumulation655,175

Excisetaxrate15%

Excisetax$98,276

The excise tax is deductible in the plan owner's federal estate tax computation, and thus the effective tax rate on the retirement assets is lower than the statutory rate of 15%. Assuming a marginal estate tax rate of 55%, the after-tax cost of the excise tax in this example would be $44,224.

In addition, if the beneficiaries realize the qualified plan assets in the year of death and do not roll them over into a separate plan, they will represent gross income to the beneficiaries upon realization. These assets are items of income in respect of a decedent. As such, their income tax basis in the beneficiaries' hands is not stepped-up to date of death fair market value.

Example 3. In this example, the estate tax payment on the plan assets would be $2,000,000 - $98,276 x 55% = $1,045,948. Since this estate tax is an itemized deduction on the beneficiary's income tax return IRC Sec. 691(C)(1)(A), the income tax paid on the $2 million of income in respect of a decedent would be $2,000,000 - $1,045,948 x 31% = $295,756, which represents an effective income tax rate of 14.8%

PLANNING TO MAXIMIZE THE

PLAN OWNER'S TOTAL

RETURN

Several options are available to owners of qualified plans to lessen taxes on retirement plan contributions. Early implementation of an appropriate planning strategy is important; as the owner approaches retirement age, fewer tax-saving options are available. Investment returns from later retirement plan contributions may be nominal. The primary planning objective is to maximize after-tax return to the family unit from funds that are available for contribution to a qualified plan, within the constraint of acceptable investment risk to the plan owner. Although qualified plan earnings accumulate on a tax-deferred basis, the disadvantages of the excise tax, estate tax and mandatory contribution requirements for the owner's employees require a careful analysis of future tax exposure before each plan contribution is made.

The level of plan accumulations at which the excise tax will apply is illustrated in Figure 1. These amounts are based on current mortality estimates used by the IRS, a discount rate of 9.6% and an annual base amount of $150,000.

At the date of death, qualified plan balances in excess of the "floor" amounts indicated in Figure 1 would be subject to excise tax on excess accumulations. For example, an individual age 55 at death with a qualified plan balance in excess of $1,276,215 would be subject to the excise tax. Note that the floor amount declines as age at death increases.

PLANNING STRATEGIES

A practitioner should be in a position to assist clients in optimizing their return on funds available for contribution to a qualified retirement plan. Three possible planning strategies that may be used to accomplosh this objective are discussed.

Investment in Alternative Assets

As an alternative to qualified plan contributions, superior returns may be gained through investment in other assets, such as mutual funds, tax-free municipal bonds or certificates of deposit. The advantage is reduced exposure to the excise tax, since investments are

FIGURE 1

QUALIFIED PLAN BENEFITS

SUBJECT TO THE EXCISE TAX

QP

AgeatDeathBalanceFloor

50$1,344,825

55$1,276,215

60$1,192,830

65$1,095,870

70$983,700

made outside the plan. However, earnings from such investments are not tax deferred, which may result in lower total after-tax returns. In the case of tax-exempt bonds, earnings would be tax free, but the rate of return would be lower than taxable investments. However, in certain cases, particularly for older investors approaching retirement, alternative investments, both taxable and tax exempt, may produce higher after-tax return, due to the high present value of the excise tax.

Lifetime Gifts

A program of lifetime gifts in lieu of contributions to the qualified plan is also a possible alternative. This method not only reduces future exposure to the excise tax but also removes assets from the gross estate of the plan owner. Additional advantages include the opportunity to test donees' management abilities and level of maturity and the intrinsic reward gained from observing the donees' current enjoyment of the property.

Donorrs can reduce the dollar amount of their estate, and avoid the gift tax, by making gifts that qualify for the gift tax annual exclusion of $10,000 per donee per year. For married donors, if a gift-splitting election is made, one-half of each f\gift is attributed to the donor's spouse. This permits a married donor to make gifts of up to $20,000 per year per donee without incurring gift tax consequences. The annual exclusion cannot be claimed retroactively. As each year passes, any unused exclusion is lost forever.

To qualify for the exclusion, the gift must be one of a "present interest;" the donee must have the immediate and unrestricted right to use and enjoy the gift property itself or the income from the property. Gifts made in trust for the benefit of minors will also qualify as "present interest" if certain requirements are met.

Accelerated Plan Withdrawals

Under Sec. 4980A, plan owners are permitted to withdraw a base amount each year without penalty, assuming the individual is at least age 59. In 1991, the base amount is 150,000. Therefore, one possible method to reduce the impact of excise tax is to cease contributions and initiate immediate withdrawals equal to the base amount. Although accelerated withdrawals would also accelerate the payment of income taxes, this would be a prudent strategy if excise tax savings exceeded the value of the income tax deferral. In addition, estate tax savings would result if withdrawals are removed from the gross estate through gifts or consumption by the plan owner. The actual payment of income taxes on plan withdrawals would also reduce the estate tax liability.

EVALUATING THE

ALTERNATIVES

As a previous example illustrated, it may not be prudent to make retirement plan contributions shortly before death. In addition, it may be advantageous to accelerate plan withdrawals to lessen the impact of the excise tax. Thus, in constructing a financial plan for retirement assets, a plan owner faces two primary decisions. First, if contributions to the plan should be discontinued, where should the funds be redirected? Second, should withdrawals from the plan be accelerated, and if so, where should these funds be invested?

To do a thorough analysis, the following information should be accumulated to evaluate the potential impact of income, estate and excise taxes:

* The amount of annual contributions made to the plan, including any expected future increases or decreases in contributions.

* The expected rate of return from the plan assets. Clearly, this is a most difficult parameter to estimate, since it involves projection for many years. An average return from prior years is probably the best estimate.

* The estimated return available from alternative investments, both taxable and nontaxable.

* The life expectancy of the plan owner, and the owner's spouse who will be the beneficiary of the plan at death.

* The estimated value of the owner's estate at the date of death. This value is necessary to estimate the marginal estate tax rate applicable to plan assets.

* The owner's marginal income tax rate, both current and in the future, together with the beneficiaries' marginal income tax rate at the date of death.

* Whether the spousal election is available.

* The level of plan contributions made on behalf of employees.

INVESTMENT IN ALTERNATIVE

ASSETS

Consider the case of a single individual who owns a qualified retirement plan. Two situations are possible. In the simple case, if the balance of the plan is below the age-based Sec. 4980A floor amount, the owner should continue making contributions since the marginal excise tax rate on these contributions is zero.

However, if the plan balance is at or above the Sec. 4980A floor amount, the contribution decision is more complicated. In this case the owner must estimate when the excise tax will apply to contributed amounts. If the time horizon is long, and the rate of return earned by the plan is sufficiently high, continued contributions may be justified. The basic question is when should contributions terminate to maximize overall investment returns? The best answer to this question requires an accurate estimate of all the information previously discussed. Perhaps the most subjective element of information is the owner's life expectancy. The longer life expectancy, the longer the period during which contributions can be prudently made. It is obviously impossible to accurately estimate life expectancy. A more realistic and practical approach to addressing this question occurs if one estimates payback period for contributions to the plan, i.e., the number of years the owner would have to live to realize sufficient benefits from income tax deferral to outweigh the negative excise tax effects.

To illustrate, assume the owner can invest up to $30,000 in a qualified plan earning a before-tax rate of 8%. This amount will be subject to income and excise taxes at date of death or withdrawal. Alternatively, to avoid the excise tax, the owner can invest the same amount outside the plan, also earning a before-tax rate of 8% and pay income taxes at a marginal rate of 31% on the contribution amount and the earnings from the investment. For this example, assume the excise tax will apply to the current $30,000 contribution in 10 years. Under these parameters, the future value of this $30,000 contribution in 10 years would be $64,768. After payment of income and excise taxes, the after-tax proceeds would be $34,975. If this same $30,000 (before taxes) had been invested outside the plan in a taxable investment, the after-tax balance in 10 years would be $35,426, the difference of $451 being attributable to the excise tax payment required on the qualified plan balance.

Assuming the owner's retirement plan balance is above the estimated floor amount, the number of years which an individual would have to live to recover the cost of the excise tax through income tax deferral, on plan contributions is illustrated in Figure 2, assuming before-tax rates of return of 6%, 8%, and 10%.

FIGURE 2

PAYBACK PERIOD FOR

QUALIFIED PLAN

CONTRIBUTIONS

Before-taxRate

ofReturnPaybackperiod

6%12years

8%9years

10%8years

These results indicate the potential severity of the penalty imposed by the excise tax on qualified plan contributions once the plan balance is above the floor amount. However, the base amount provided to plan owners is very generous. Younger plan owners can thus make significant contributions to their plan before the impact of the excise tax is realized.

The Impact of Employee

Contributions on Qualified Plan

Returns

In a atypical profit-sharing type retirement plan, the owner is required to make contributions on behalf of employees if contributions are also made to the owner's account. An unfortunate and unintended side effect of the excise tax is the creation of an incentive for the owner to reduce or eliminate contributions made on employees' behalves. Clearly, if the return from the owner's contribution is low (or even negative), the financial advantage from making employee contributions is negligible. Of course, nonfinancial factors are involved in the employee contribution decision, such as employee morale, firm reputation, and recruiting of personnel. If contributions for the owner and employees are reduced or eliminated, the owner could adopt alternative strategies to appease employees, such as direct cash payments in lieu of retirement plan contributions, with significant cost savings available.

GIFTS TO FAMILY MEMBERS

As discussed, a decission to make a retirement plan contribution involves a possible trade-off between future excise tax payments and income tax deferral. An additional issue which must be addressed is the impact of the estate tax on future plan balances. At death, the fair market value of the plan is included in the decedent's gross estate, with no step-up in basis permitted to the beneficiaries. With current estate tax rates ranging from 37% to 55%, the potential estate tax paid on the decendent's plan assets may be severe. Therefore, in evaluating the plan the owner must also consider the alternative of a program of lifetime gifts or consumption.

For example, if the owner's life expectancy is assumed to be 10 years, a program of gifts of the $30,000 annual contribution may be prudent. Income taxes would be increased by not receiving the deduction for th eplan contributions, but the assets would be removed from the estate, producing potentially large estate tax savings. Assuming an estate tax rate of 55% and a marginal income tax rate of 31%, the following result would be obtained

Dateofdeathvalue

($30,000investedfor

10years,8%annual

growthrate)$434,597

Excisetax$65,190

Estatetax203,174

Incometax71,741

Totaltaxespaid$340,105

After-taxbalance$94,492

If, instead, the $30,000 contributions had been removed from the estate through a program of gifts to family members, the after-tax balanced available to the family unit at death would be $266,769. This represents an increase of 182% over the qualified plan investment and is due to the avoidance of the excise and estate taxes on the accumulated balance at death. Similar differentials exist for other assumed growth rates.

ACCELERATED

WITHDRAWALS

Assuming that the owner's plan analysis suggests a discontinuance of plan contributions, the final question to the addressed is whether withdrawals from the plan should be accelerated to avoid the excise tax. As in the case of plan contributions, accelerated withdrawals involve a trade-off between excise tax savings and income tax deferral. Recall that withdrawals from a qualified plan for an individual who is at least age 59 are not subject to the exercise tax up to the base amount each year, which currently is the greater of $136,204 (indexed for inflation) or $150,000. Although withdrawals are subject to income taxes, excise tax savings would result. An analysis similar to that performed in the alternative investment situation would be required to determine the appropriate strategy for each individual plan owner.

THE PRUDENT PLANNER

To minimize the effects of Sec. 4980A and the estate tax on retirement plan investments, each participant in a qualified retirement plan must analyze future consequences of continued contributions to the plan. A redirection of plan investments to other investments or gifts to family members may produce greater financial returns. In addition, it may be prudent to accelerate plan withdrawals if the excise tax will apply to future withdrawals or accumulations. A careful analysis of income tax deferral benefit compared to advantages of excise and estate tax savings should be made to maximize retirement plan assets.

ENDNOTES

(1) For purposes of Sec. 4980A, a qualified employer plan includes any qualified pension, profit-sharing or stock bonus plan under Sec. 401(a), and any Sec. 403(a) or (b) annuity. Individual retirement plans are individual retirement accounts and individual retirement annuities described in Sec. 408. In addition, distributions from any plan, contract or account that at any time was ever treated as a qualified employer plan or individual retirement plan are also considered to be retirement distributions. Temp. Regs. Sec. 54.4981A-1T, a-3.

(2) The 1991 indexed amount is $136,204 IT-91-12.

(3) An exception applies if one or more persons other than the spouse are beneficiaris of a de minimis portion of the accumulated plan interests. In such a case, a spousal election may still be utilized.