Planning for large retirement savings at death: payout strategies for minimizing taxes.

• Author: Weber, Richard P.

The various retirement tax-deferred savings vehicles (TDVs) provided in the tax law (e.g., Sec. 401(k) plans, individual retirement arrangements (IRAs)) are generally very advantageous. By deferring tax on income accumulated in TDVs, taxpayers can generate a larger after-tax income stream at retirement than would otherwise have been possible. However, one consequence of using TDVs is that funds remaining in them at the saver's death may be subject to estate tax, income tax and, possibly, excess accumulations tax. This article discusses the benefits of using TDVs, the tax consequences when funds remain in them at death, and planning to mitigate those consequences.

Lifetime Advantages of Using TDVs

There are at least two major advantages to saving through TDVs: they allow a taxpayer to (1) generate a larger future income stream by accumulating more assets and (2) shift income from a higher bracket (during working years) to a lower one (during retirement years). Example 1: Individual X has $1. His combined Federal (39.6%) and state (0.4%) tax rate is 40%; his rate of return on a 20-year investment is 10%. Thus, after taxes, X has 60 cents to invest. This will grow at an after-tax rate of 6% (0.10 (1.00 - 0.4)), yielding $1.92 at the end of 20 years; after that time, it will generate an after-tax income stream of $0.12 ($1.92 x 0.06) per year. if the dollar were instead saved in a TDV, the pre-tax yield would be $6.73 ($4.04 after taxes) at the end of 20 years; the $1 would generate an after-tax income stream of $0.40 ($6.73 X 0.061 per year thereafter. The deferral allows X to more than double the after-tax value of his retirement assets, or triple the retirement income generated by the discretionary dollar. The increase is a function of the tax rate, the rate of return and the savings period.

The second advantage of tax deferral occurs only if X earns $1 when it would otherwise have been subject to a 40% tax rate and collects it when his marginal tax rate is zero. Actually realizing this is unlikely; to achieve it, X would have to earn more than $256,500 of taxable income while saving and have TDV income less than his personal exemption and standard deduction during retirement. X would more likely drop to a 28% bracket at retirement than the zero bracket. In fact, heavy use of TDVs by a taxpayer may result in no decrease in tax rate at retirement and may raise the tax rate because of the 85% inclusion of Social Security income.

Consequences of TDV Savings at Death

Generally at death, $1 left to an heir results in an actual bequest of anywhere from 40 cents to $1, depending on the decedent's estate tax rate. if no estate tax is owed, the heir receives $1; if the decedent's estate is taxed at the highest marginal estate tax rate (60%), the heir receives 40 cents. This simple result becomes more complicated if the bequeathed dollar is in a TDV, because then, the dollar is subject not only to estate tax, but also to income tax as Sec. 691 income in respect of a decedent (IRD). The beneficiary will be entitled to an income tax deduction for the estate tax paid on the dollar (under Sec. 691(c)(1)), but the deduction may be reduced by as much as 80% under the Sec. 68 phaseout rules. Other itemized deductions (e.g., medical expenses) that are subject to a threshold based on a percentage of adjusted gross income (AGI) will also be affected. In addition, the dollar may be subject to the Sec. 4980A 15% excise tax on excess accumulations (as defined in Sec. 4980a(d)] and distributions (defined by Sec. 4980A(C)(1)(A) as more than $150,000 per year). The excise tax is deductible under Sec. 2053 in computing the estate tax, but, according to Sec. 691(c)(1)(C), does not generate an itemized deduction.(1)

Example 2: One dollar in a TDV subject to the See. 4980A excise tax passes from decedent Y, whose estate is subject to a 60% tax rate. Z...