Maximizing distributions while minimizing the grandfather amount. (Employee Benefit Plans)by Berman, Kevin
1. maximize their distributions from retirement plans, while 2. avoiding the excess distributions tax, while 3. preserving the maximum grandfather amount for use in the future.
For some taxpayers, a simple algebraic formula can be used to calculate the amount of distributions necessary to achieve these results.
The Excess Distributions Penalty
IRC Sec. 4980A imposes a nondeductible 15% excise tax on excess distributions from retirement plans. The tax applies to aggregate distributions from all qualified plans, IRAs, and IRC Secs. 403(a) and 403(b) annuities of an individual. The excess distribution is the aggregate amount of the retirement distributions during any taxable year to the extent that such amount received exceeds a threshold amount, which is the greater of--
1. $150,000, or;
2. $112,500, adjusted at the same time and in the same manner as under IRC Sec. 415(d). IRC Sec. 415(d) prescribes annual cost-of-living adjustments (i.e., indexing for inflation).
For 1993, the $112,500 indexed for inflation is $144,551. Once the indexed amount reaches $150,000 or more, the threshold amount will be the same for all individuals, regardless of whether a grandfather election was made.
The excess distributions tax is reduced by the amount of any early distribution penalty per IRC Sec. 72(t). Also, certain distributions are excluded, including distributions of the individual's nondeductible contributions to the plan (but not any income earned thereon), distributions made to an alternate payee under a qualified domestic relations order ("QDRO"), the value of distributed annuity contracts excluded from gross income, and amounts excluded from gross income because they have been rolled over. The excise tax on lump-sum distributions is calculated separately from all other distributions taken during the year. The applicable threshold amount for lump-sum distributions is five times the ordinary threshold amount.
The Grandfather Election
IRC Sec. 4980A(f) provides an election for individuals who had total accrued retirement benefits in excess of $562,500 on August 1, 1986. Such individuals could "grandfather" the total benefits accrued at that date in all qualified plans and IRAs. The election must have been made on a return for a tax year ending after December 31, 1986, and before January 1, 1989 (the 1987 or 1988 taxable year). The election was made on Form 5329, which was attached to the tax return for the year of election. A copy of Form 5329 for the year of election must be attached to the tax returned for all subsequent years in which the individual receives excess distributions (determined without regard to the grandfather rule).
The excess distributions tax does not apply to the distribution portion that represents a recovery of the initial grandfather amount. The grandfather amount is reduced by such recovery. Those individuals who made the grandfather election must use the $112,500 indexed for inflation threshold amount, as opposed to the larger $150,000 threshold amount.
The grandfather amount is recovered under one of two alternative methods:
1. The attained age method, or 2. The discretionary method.
Attained Age Method
Under the attained age method, the rate of recovery is calculated based on a formula that takes into account the individual's age, both on August 1, 1986, and at the end of the year in which the retirement distribution is received. The recovery rate formula is:
The rate of recovery diminishes as the individual ages.
The discretionary method is more widely used than the attained age method. Under the discretionary method, 10% of the total retirement distributions received from qualified plans and IRAs during a calendar year are treated as a recovery of the grandfather amount.
An election is available to accelerate the rate of recovery to 100% of the distribution. Once made, this election will be effective for all subsequent years. It can be made (or revoked) on a timely filed amended return for any prior years to which the discretionary method of recovery applied. It becomes irrevocable once the period for amending the return for the year of the election has expired. The acceleration election is made on Form 5329, which is attached to the return for the year of election. The example below illustrates the use of the discretionary method.
Howard Zappa is 67-years old. The total accrued benefit in all of his qualified plans and IRAs as of August 1, 1986, was $1,000,000, and he made a timely grandfather election. He has received distributions in prior years, and has utilized part of his grandfather amount to avoid excess distributions tax from these distributions.
In 1993, he received a total of $250,000 of distributions from his qualified plans and IRAs. Table 1 is a comparison of the use of the 10% discretionary method, and the acceleration (or 100%) method.
When comparing the current tax effect of the two methods, an obvious question comes to mind. Why would anybody choose not to make the acceleration election (and therefore not get the benefit of the 100% method)? The answer is that the election of the acceleration method may not be suited to all situations for the following reasons:
1. The participant's estate may be liable for a 15% excess accumulations tax, as an addition to the estate tax. This tax generally applies to the value of the decedent's interest in qualified plans and IRAs as of the date of death (or alternate valuation date). The remaining grandfather amount at the applicable date may serve to reduce this tax. The amount that serves to reduce the tax is the greater of: a) the remaining grandfather amount, or; b) a period certain annuity of the threshold amount, indexed for inflation, for the period of the individual's life expectancy, as of his or her date of death. Thus, a careful integration of estate, income tax, and financial planning is necessary to determine whether the acceleration election will be beneficial.
2. For purposes of computing the excess distributions tax, if the 100% method is elected, the participant never receives any benefit from the threshold amount. The following example illustrates this point.
Assume the same facts as in the earlier example, except the 1993 distribution is $160,612.
In this example, the distribution has been tailored (in the 10% method scenario) to avoid the tax, while using the minimum grandfather amount. A simple algebraic formula was used to determine the amount of distribution that would achieve these results. The formula is below:
X = Threshold amount (for the year of distribution) + .10X
Applying this formula to our example, the result is as follows:
X = $144,455 + .10X .90X = $144,551 X = $160,612
For individuals that have a grandfather election in place, careful integration of estate, income tax, and financial planning is necessary to determine whether the acceleration election (the 100% recovery method) under the discretionary recovery method will be helpful. For those that do not make the acceleration election (and therefore use the 10% recovery method) a simple algebraic formula can be used to achieve beneficial results. Use of the formula will determine the distribution amount necessary to avoid the excess accumulations tax, preserve the maximum grandfather amount, and maximize distributions.
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