Tax confiscation of IRA benefits.

• Author: Miller, Michael D.

The benefits of individual retirement accounts are well-known to most Americans. IRAs allow individuals to set aside a modest amount of money each year for retirement in a tax-deferred vehicle, without any action by their employers and without many of the onerous requirements applicable to qualified retirement plans. Also, subject to certain conditions and limitations, the contribution amount reduces the individual's adjusted gross income. IRAs not only reduce taxes currently, but also enable the individual to accumulate funds on a tax-deferred basis. Indeed, it is because of these significant advantages that, between 1979 and 1993, 119.3 million returns claimed over $256 billion in IRA deductions.(1)

What is not well-known is that individuals who die with substantial amounts invested in IRAs will face combined tax rates in excess of 70 percent. This means that, absent proper planning, IRA contributions growing on a tax-deferred basis over a long period of time might ultimately be depleted by taxes to such an extent that the beneficiaries will receive no more than 30 cents of each dollar held in the IRA.

Please note that the same tax erosion concerns also apply to distributions from qualified retirement plans. However, to focus the analysis this article only addresses distributions from IRAs.

Potential Taxes at Death

IRA distributions made upon the death of the owner are potentially subject to income, excise, estate, and generation-skipping transfer tax. Upon death, the fair market value of the IRA assets payable to an owner's estate or to the owner's beneficiaries is included in his or her gross estate for federal estate tax purposes. If the IRA does not pass to a surviving spouse in a manner that qualifies for the marital deduction, the IRA will be subject to federal estate tax, with rates ranging from a low of 37 percent to a high of 60 percent (for taxable estates, i.e., estates in excess of $600,000).(2) If an IRA owner leaves some or all of the plan benefits of the IRA to a skip person (such as a grandchild),(3) and if such amounts do not qualify for the $1 million generation-skipping transfer tax exemption, then the devise will also trigger generation-skipping transfer tax at a rate of 55 percent.(4)

In addition, IRA proceeds distributed at death are potentially subject to an additional 15 percent estate tax on "excess retirement accumulations." An individual's excess retirement accumulation is the excess, if any, of 1) the value of the decedent's interest in all qualified retirement plans, employee annuity plans, tax-sheltered annuities, and IRAs determined as of the date of death (or the alternate valuation date, if an election is made under IRC [sections] 2032), over 2) the present value of a single life annuity that would have been payable to the decedent based on the decedent's age at death, with annual payments equal to the annual threshold amount (as in effect in the year in which death occurs).(5)

Finally, let us not forget income taxes. Unlike most investment assets (e.g., stock and real estate) owned personally, IRA assets constitute income in respect of a decedent and do not obtain a date of death fair market value basis. IRC [subsections] 1014(c) and 691. As a result, because the IRA contributions (assuming they were deductible when made) and the appreciation thereon have never been subject to income taxes, the entire amount distributed will be taxed as ordinary income. No portion of the distribution, not even the amount equal to the appreciation, will be taxed as capital gain. Therefore, an IRA has two important negative income tax consequences as compared to most investment vehicles--no date of death fair market value basis and no capital gains treatment. This tax hardship is marginally alleviated by allowing an income tax deduction, which is based on the federal estate tax generated by the IRA assets.

In order to quantify the effect of these multiple layers of taxation (and in order to illustrate the problems associated with accumulating large IRA balances), assume that your client John Smith, is 54 years old, and has an IRA balance of $250,000. Assuming that John...