IRS Information, Regulations and Commentary on Charitable Legal Issues

Excess Accumulations in a Qualified Plan

Excess Accumulations in a Qualified Plan

Pension Traps for the Well Heeled

Excess Accumulations in a Qualified Plan — Why Some Participants May Want to Opt Out

It’s been said that the rich are not like other people. In fact, they have a whole set of problems that many of us cannot fully appreciate. Tax simplification and reduction may be popular political goals, but historically, Congress has nibbled away at the wealthy and their right to control personal wealth. A good example of this double standard is the excise tax trap in which many of the prosperous find themselves at retirement. Too much of a good thing obviously had to be penalized somehow.

While Congress dreams up new ways to wring more dollars out of the well to-do, the IRS has special regulations available right now to make life for wealthy savers more taxing. Conventional wisdom holds that the rich already have too many special tax breaks. In reality, for the well heeled, previous changes in laws have completely destroyed many of the same shelters and techniques that still benefit poor and middle class taxpayers. Income tax deductions are consistently eliminated, and net tax rates moved up without much opportunity to squawk from taxpayers. It is these gradual changes that have had such a big impact on the bottom line for many people looking to minimize tax hits on their assets. Even though published tax rates are lower now than in earlier years, without their old deductions, the taxes paid are higher and spendable income for many is actually much less. When politicians talk about tax relief, they cut in one area and increase in others.

The recently passed Taxpayer Relief Act of 1997 has eliminated the 15% excise tax on distributions during life as well as in estates. However, normal income and estate tax liabilities were kept in place. Since few estate tax breaks were passed in this legislation providing relief for professionals with significant estates, keeping a close eye on uncontrolled appreciation remains important. With the loss of §664 Trusts as a tool to pass down retirement plan assets for young beneficiaries, extra care needs to be taken with plans for some families with wealth.

As an example of the incremental hike in tax rates, the pension tax laws are a classic example of ways the government creatively generates new revenues. Pension savings were fully exempt from estate taxes as late as in 1981. Over the next five years, those qualified retirement savings plans (QRP) were gradually exposed to estate taxes and by 1986 were completely subject to tax liabilities, now at 55% for many estates. All of these backdoor tax increases occurred while big income tax cuts were simultaneously passed and promoted for general public consumption.

Once promoted as an ideal way to safeguard the future, qualified retirement plans may not work as originally intended for the top 5 – 10 percent of plan participants. Highly compensated pension participants, urged by their advisors to defer salary into qualified plans, may have put themselves into a trap with few options to control those funds. Savings, they were told, could be withdrawn as needed and theoretically used in a lower tax bracket. It was also assumed that flexible use in retirement would allow the retiree discretion in how those funds were exposed to tax. Today, it turns out that most wealthy retirees still pay taxes at the highest marginal income tax rates. Since 77 per cent of the nation’s wealth is held by those over 50 years of age, tax rates have stayed high to reflect that reality. Other planning assumptions about unused retirement savings being available to create an estate for heirs have also been proven wrong. The oft-heard advice to defer more income into retirement plans may be exactly the wrong thing to do today for many affluent savers. Not that saving in a tax-deferred environment is bad, it just may need to be repositioned for more efficiency.

When is this threshold for new taxes going to be an issue? The biggest problem exists if there is any potential for estate taxes and there are already significant assets in a qualified plan. Instead of the family receiving those unused retirement plan funds, about 75% will pass to the IRS upon the taxpayer’s death (income in respect of a decedent or IRD). Capital punishment in every sense of the word, estate and income taxes effectively confiscate almost all of the sheltered savings. These exposed funds include money in pensions, profit sharing and 401(k) programs, as well as 403(b), IRA and HR-10 (Keogh) plans. At greatest risk of loss are the self-employed, professionals and small business owners who maximized their plan contributions every year and now have accounts that will approach $1 million by retirement. For most savers, that seems like an unreachable goal, but compounding interest and maximum contributions may make it commonplace for those with good programs.

Where did it all go wrong? To fill a social need, Congress created legislation to encourage taxpayers to set aside funds for retirement. Nobody disputed that saving for the future was a desirable goal and should be encouraged with favorable tax treatment. As a result, motivated company owners used qualified plans in a tax deductible environment to grow their nest egg without the burden of current taxation. Unfortunately, for the IRS, too much money was withdrawn from the tax collection system and it reduced needed tax revenues. So new laws were drafted to make it harder to save in retirement shelters. Today the IRS can effectively penalize a taxpayer if they save too much, withdraw savings too early or too late, and if they take distributions that are too large or too small. Mortimer Caplin, former director of the IRS, summarized it well, “There is one difference between a tax collector and a taxidermist — the taxidermist leaves the hide.”

Congressional budgeters view the huge pool of deferred savings as a cash cow to be milked for future revenue enhancements. For example, when federal unemployment benefits needed to be lengthened in 1992, Congress financed the program by changing the tax treatment on rollovers from qualified plans. They projected that most taxpayers would not jump through all of the hoops creating new tax revenues and penalties to produce the needed funds. Unfortunately, they were right.

If you think you might be one of those exposed to unnecessary taxation. There is specialized computer software available to project tax problems and liabilities for retirement plans, and qualified tax and financial advisors should be consulted to minimize any potential for losses. With creative planning, new strategies recently granted IRS approval could also eliminate many of the obstacles for successful savers. However, action needs to be taken early and the program monitored carefully. Properly done, the value of a qualified plan can be used to fund retirement, and still pass any remainder of the estate to heirs without penalties.

© Vaughn W. Henry, 1995 and 1997