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Retirement Planning for Estates
ver the past generation, retirement assets have become an increasingly important part of many modern estates - a cultural development that we discuss on page four. Meanwhile, the taxation and distribution of retirement assets have significantly changed.1 The net effect: Estates that are not prepared to cope with the impact of a newly dominant asset.
Let us therefore direct our attention to the recent repeal of the 15% success taxes on excess distributions and accumulations, the estate-planning opportunities associated with the new Roth IRA, and the heightened importance of selecting retirement plan beneficiaries. Let's review these and other key developments and strategies for retirement assets that every estate planner should be aware of.
Success Taxes, Begone!
If it were only so easy to extinguish other taxes with as much dispatch as Congress applied to the so-called "success taxes" on excess distributions from retirement plans as well as excess accumulations.
A Window Opens
Under HIPAA '96, a window of opportunity opened in that the 15% tax on excess distributions was suspended for retirement events occurring for years beginning after 1996 and before 2000, i.e., 1997, 1998, and 1999. Those subject to such a tax were also encouraged to take advantage of the suspension period because large retirement assets could end up being subject to the 15% tax on accumulations in the future.
Game Over
Less than one year later, the Taxpayer Relief Act of 1997 eliminated both success taxes, effective for excess distributions received after December 31, 1996, and for accumulations in the estates of decedents dying after December 31, 1996.
Shifting Gears
In the absence of success taxes, certain retirees had to reconsider any distributions that had been set in motion and make a 180-degree shift. Instead of accelerating a distribution to take advantage of the window for the temporary suspension of the taxes, it suddenly made sense (for certain retirees) to postpone distribution of retirement plan assets for as long as possible to continue taking advantage of tax-deferred growth.
Repercussions
What will the consequences of this change be? Here's one theory: Max Doe is delighted to learn that he can now max out his retirement contributions without fear. His sizeable pool of retirement assets already accounts for 40% of his net worth. By redirecting more assets into retirement plan contributions, let's say the balance of Max's estate shifts and is now 50% retirement assets. Max finally retires and has no further employment income. But contrary to his financial planner's projections, his expenses do not fall during retirement. With more time to travel, indulge hobbies, buy cars for his children, and make charitable contributions large enough to be celebrated with bronze plaques and a picture in the local newspaper, Max's retirement is expensive.
Maximum Deferrals
Does Max finance his life-style with retirement assets? No. Since it generally makes sense to preserve assets in their tax-deferred state, compounding happily, there is a prevailing school of thought to minimize plan distributions and use other unsheltered assets to finance the retirement years.
Alternatives
An immediate caveat: Maximizing deferrals is not necessarily the right move in every circumstance. There are conflicting income tax and transfer tax issues at play. And consider the unbalanced estate that such an approach may produce. In any event, our prototypical (and aptly named) retiree is programmed to maximize his deferred assets. As a result, the huge retirement pool of assets is barely diminished, while the remaining assets of the estate are being exhausted. At Max's death, his retirement assets account for 80% of his estate.
Deferring Distributions
Note that other recent changes have a bearing on the timing of plan distributions. For example, starting in 1997, required distributions for participants (other than those who own at least 5% of a business) can be deferred until actual retirement if later than age 70 1/2.
Roth IRA implications
And now for something completely different. The Roth IRA looms as a watershed event. Not since the advent of the IRA itself have the retirement plans of so many people been potentially redirected to a major new financial-planning opportunity.
Standard Tax Deferral
With the exception of the new Roth IRA, all retirement plans - from the mighty corporate pension and profit-sharing plans that shift the tides of the financial markets, down to the smallest, plain vanilla, $2,000-a-year IRA - are designed to defer income taxation until distribution, there by allowing rapid tax-sheltered compounding of assets. However, the ultimate payload of retirement dollars is subject to income taxation upon distribution.
Roth Deferrals
The Roth IRA reverses the typical IRA process and allows the payment of tax up front. Assets accumulate income without triggering any tax and are distributed without additional income tax. As with most IRAs, a 10% penalty applies to early distributions, i.e., those which are before age 59 1/2 or which are not made upon death or disability. But where standard IRAs and pension plans must begin minimum distributions by a required beginning date (RBD)(and must carefully select beneficiaries to extend joint life expectancies and therefore reduce the required minimum distributions), the Roth IRA has no minimum distribution requirements during the settlor's lifetime.
The Roth IRA Trust
For estate-planning purposes, the Roth IRA constitutes an asset with several very attractive attributes: (a) it won't be reduced by required distributions; (b) it won't be reduced by income taxes; and (c) it will be relatively liquid in that it will probably consist of readily saleable stocks and mutual-fund holdings. This makes a Roth IRA a reliable asset which with a trust fund can be financed.
Additional Strategies
Alas, we were just getting started on this highly important area. Let us therefore use our remaining space to note, without necessarily endorsing, a variety of points noted in recent articles.
Spousal Interests
Since spouses have protected retirement interests under the Retirement Equity Act, it is important to obtain a valid waiver of spousal interests before designating beneficiaries other than a spouse. However, in many estates, designating the spouse (or, for example, a credit shelter trust) as the beneficiary of a retirement plan will often make sense.
Beneficiary Designations
Naming the estate as the beneficiary of a retirement plan is generally ill advised. This may expose certain plan benefits to income taxation at the relatively high rates of the estate. In addition, by naming other individuals or trusts as beneficiaries, a longer life expectancy is achieved for calculating the minimum required distributions under §401(a)(9). Naming a child or grandchild can be most advantageous. Where an estate is named as the plan beneficiary, post-mortem disclaimers may be useful.6 Using separate IRA accounts for different beneficiaries may have tax and investment advantages.
Life Insurance
There are several advantages and specialized techniques associated with the use of life insurance in retirement plans.(8) Once approach involves a qualified plan purchasing life insurance using a sub-trust. As an alternative to a qualified retirement plan, a life insurance private pension involving an irrevocable trust might allow lifetime access to the policy's cash value while excluding death benefits from estate tax. These techniques are not necessarily recommended.
Charitable Gifts
With the combined estate- and income-tax burden exceeding 75% on some retirement assets, charitable gifts are highly attractive. Beware, however, of complex and uncertain income tax consequences of utilizing pooled income funds or a deferred gift such as a charitable remainder trust.
The Dawn of a New Age
The post-modern retiree has been given unprecedented freedom to call the shots in shaping a retirement arrangement. With so much incentive to build large tax-sheltered retirement funds and roll them over as long as possible, retirement assets will be the centerpiece of many estates, requiring a rethinking of how retirement beneficiaries are designated and which estate-tax strategies should be employed.
We will undoubtedly have to revisit this area to keep up with changes and continue our discussion of relevant estate-planning strategies for retirement assets.
Retirement Retrospective: A Societal Shift
Over the course of the last generation, retirement assets have taken on greater significance for estate-planning purposes. Why? How did we come to this point in time when more than 50% of an estate may consist of a stock- and mutual-fund-oriented IRA rollover account?
The Bad Old Days
Once upon a Time, the typical estate could expect little more than an employer's death benefit (for which a minor exemption had existed until recently)2 or a modest annuity. Significant corporate coverage was "top heavy," i.e., primarily for the benefit of upper-echelon boardroom inhabitants. A generation ago, with the lessons of the Great Depression freshly imprinted on our collective psyche, and the stock market taking decades to push the Dow Jones industrial average over the 1,000 level3, the stock market wasn't for everyone. Back then, an individual contemplating retirement might purchase an annuity or tax-free bonds.
The Individual in Charge
New Rules Require Equity: The advent of ERISA in 1974 was part of a sea change in the role of corporate retirement planning. With ERISA came the age of inclusion. Restrictions on top-heavy contributions and democratized participation rules established new guidelines for equitable treatment. Subsequent laws cultivated individual participation on several levels, such as 401(k) plans with elective deferrals for employees and SEPs for small businesses.4 And IRAs became on overnight phenomenon.
A Receptive Public
Did people change in reaction to the new laws, or were the new laws simply manifestations of societal changes? Consider the demographics: (a) People are living longer, so retirement years are being extended in length. (2) People are having healthier, more active retirements with higher expenses. (3) The baby boomers, 77 million Americans, have started turning 50, causing retirement needs to come into sharper focus.
Gravity
With other tax-saving techniques curtailed during the tax reforms of the 1980s, and tax-sheltered retirement opportunities being expanded, it should come as no surprise that personal assets gravitated toward retirement arrangements. It also makes sense that such assets would be left untouched to maintain tax-deferred benefits while other assets are exhausted. Retirement assets are also rolled over, e.g., to a surviving spouse's IRA. Ipso facto, retirement funds can snowball into the last major asset of an estate.
The Market Context
The Good Times Roll: One cannot overlook the bull market's relationship with the growth of retirement plan investments. Over the past decade, the Dow Jones industrial average rose about 7,000 points.6 Everyone with $100 to invest wanted a piece of the action, and with their self-empowering IRAs and 401(k)s, individuals were finally in a position to jump in.
The Gold Rush
How can individuals create diversified portfolios with small IRAs? Voilą, mutual funds arrived right on cue and the doors to the stock market flew open to the general public, flooding the financial markets with enough capital to float the markets higher still - the confidence of baby boomer investors has become a self-fulfilling prophecy.
References
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TECHNICAL REFERENCES
1. For recent changes, see, Ice, New laws make broad changes in retirement plans and IRAs, 24 EP 1, p.8 (Jan., 1997). We covered basic distribution requirements in, A gameplan for the modern retirement estate, The Estate Anaylst (May, 1994). See also, Doherty, Strategies for large retirement plan account balances, 22 EP 4, p. 218 (July, 1995); Mezzullo, Planning for distributions from qualified retirement plans, 132 T&E 11, p. 30 (Nov., 1993)(an excellent treatment of the subject, though dated).
2. IRC §4980A, which applied a 15% tax on excess distribution on amounts exceeding $160,000 (or five times that amount for lump-sum distributions), was repealed by TRA '97, Act §1073(a).
3. IRC §401(a)(9)(C), amended by SBJPA §1404. In addition, five-year-averaging treatment of retirement plan distributions is terminated after December 31, 1999. However, 10-year averaging remains available to those who qualify, i.e., persons born prior to 1936. IRC §402(d), amended by SBJPA §140(a).
4. Wilf, Innovative estate planning strategies using Roth IRAs, 25 EP 3, p. 99 (March, 1998). Wilf, who has no less than three superb articles cited among these footnotes, describes an irrevocable Roth IRA trust that will make no distributions to anyone during the settlor's lifetime and is distributed to the usual beneficiaries at death. So establishing the trust constitutes an immediate taxable gift (for which the unified credit may be applied) but the Roth IRA is subsequently excluded from the taxable estate at death. Caveat: There are gray areas in the transfer tax treatment of Roth IRAs. Although Wilf's discussion of supporting statutory authority may be convincing, any new approach tends to receive heightened scrutiny and may be the subject of corrective, and retroactive, tax legislation. As Wilf concludes, there are risks and rewards to be weighed. Note also how protection of the Roth IRA, as with maximizing deferral of with other retirement plans, may create an unbalanced estate that is dominated by the Roth IRA assets. For a discussion of trust with regular IRAs, see Schettenhelm, Recent developments highlight plan and IRA beneficiary designations, 24 EP 6, p. 274 (July, 1997). See also, Silfen, Roth Ira or Regular IRA: How to decide which one is preferable, 25 EP 3, p. 108 (March, 1998).
5. Wilf, Informed consent by spouse necessary to waive plan benefits, 24 EP 6, p. 251 (July, 1997); Talavera, Mobley, and Johnson, What are a spouse's rights in retirement plans and IRAs?, 23 EP 3, p. 109 (March, 1996).
6. Wilf, Customizing IRAs to serve a client's specific needs best, 25 EP 4, p. 147 (May, 1998); Harker, IRA beneficiary designations: Who gets it when you go? 136 T&E 6, p. 49 (May, 1997); Moore, A marriage of convenience: The credit shelter trust and qualified plan and IRA benefits, 24 EP 2, p. 83 (Feb., 1997); Adams IRA beneficiary, 135 T&E 12, p. 55 (Nov., 1996); and Moore, A sorry 'estate' of affairs for qualified plan and IRA benefits: Naming an estate as beneficiary, 23 EP 8, p. 385 (Oct., 1996).
7. Sennett, Achieving investment objective through separate IRA accounts, 133 T&E 11, p. 44 (Nov., 1994)(an excellent idea that remains widely overlooked). See also, Wilf (fn.6, supra) regarding separate IRAs for GST purposes.
8. Sardis and Jenei, Creating a life insurance private pension via split dollar, 25 EP 2, p. 51 (Feb., 1998); and Falk, Using life insurance in qualified retirement plans, 23 EP 8, p. 357 (Oct., 1996).
9. Freeman, When to give retirement plan assets to charity, 21 EP 6, p. 348 (Nov., 1994); and Hoyt, Charitable gifts from donors' retirement plan accounts, 133 T&E 8, p. 20 (Aug., 1994).
LEGEND: EP = Estate Planning (WGL); T&E = Trusts & Estates.
1. Stocks recently surpassed real estate as the number-one asset of the American household with 28% of wealth invested in stocks.
2. Retirement benefits were once small and precious enough to be entirely excluded from estate tax. This exclusion was scaled back to $100,000 by the Tax Equity and Fiscal Responsibility Act of 1982, and then eliminated entirely by the Tax Reform Act of 1984. The $5,000 death benefit income tax exclusion under §101(b), which resided in the tax code for half a century and once was enough to buy a house, was repealed for decedents dying after August 21, 1996, by SBJPA §1402(a) - at which point $5,000 no longer covered the cost of an average funeral.
3. The Dow took 40 years to rise from a Depression low of 41 points to 1,000 in 1972. It then took 15 years to reach 2,000 in 1987.
4. Small-business employers can now establish savings incentive match plans (SIMPLE plans) that essentially take the place of salary-deferral plans. Employers with fewer than 100 employees and who do not maintain other retirement plans may create these IRA-based SIMPLE plans. Nondiscrimination rules and top-heavy rules don't apply. Elective contributions to an employee's simple retirement account (SRA) are limited to $6,000 in 1997 and are indexed for inflation thereafter. IRC §§72(t)(6), 402(k), 404(m), 408(d)(3)(G), and 408(p), amended by SBJPA §1421. SIMPLE 401(k)s may be adopted under the same rules as the simple SRAs described above. IRC §401(k), amended by SBJPA §1422(a) and (b).
5. IRA participation was liberalized in 1981 and peaked with $40 billion of deductible contributions in 1986. After restrictions were imposed on eligible contributions by TRA '86, only $8.2 billion of deductible contributions were made in 1992.
6. After Black Monday in 1987, the Dow rose 500% over the next decade to reach the 9,000 level. Although the current marketplace can shift 1,000 points in less than a year, that amount represents less than 15% of the overall market.
7. Mutual funds have existed for many years, but have exploded in popularity and variety only over the past decade. The 1990s have been a mutual-fund gold rush. Billions are flowing from individuals into such funds, causing popular funds to max out in capital and close out new investors just to remain manageable. There are now more than 7,000 mutual funds containing $3.4 trillion, and new funds keep arriving.
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