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Unpleasant surprise! Tax deferred funds may face triple tax threat
LITIGATION AND LEGISLATION UPDATE Litigation and legislation of particular interest to orthodontists will be reported under this section of the American Journal of Orthodontics and Dentofacial Orthopedics. Manuscripts for publication, readers' comments, and reprint requests may be submitted to Laurance Jerrold, DDS, JD, 100 Clark Ave., Massapequa, NY 11758
Unpleasant surprise/Tax deferred funds may face triple tax threat Thomas B. Kret* Schaumburg, Ill.
Our whole lifetime we are told to start saving early for retirement, and the best place is through a qualified plan (IRS, 401(k), TSA, Pension, Profit Sharing). Where else can you accumulate money on a pretax-tax basis, have it grow tax-deferred, and, in some cases, receive favorable tax treatment when you take it out at retirement age? This is the standard advice we all receive. What you typically do not hear is that if you are successful in accumulating large sums of tax-deferred assets, you face a triple tax threat when your estate passes from one generation to the next. The triple stands for the three separate taxes that potentially apply to qualified plan distributions: 1. Federal Income Taxes Deferred assets do not receive a step up in basis; consequently, the heirs must pay income taxes when the funds are distributed. If the assets are all distributed in 1 year, this may cause income tax at the highest marginal income tax bracket of 39.6%. 2. Federal Estate Taxes Large estates may be taxed at the highest estate tax rate of 55%; a large qualified plan distribution may push the estate into that bracket. 3. Excess Accumulations Tax Lastly, there may be an excise tax of 15% on the portion of the distribution that is determined to be an excess accumulation. The chart below is an example of the potential qualified plans shrinkage based on a pension of $1,500,000 in a taxable estate of $3,500,000, and death occurring when a person is 58 years old at a time when the Applicable Federal Mid-Term Rate is 8%. We further assume that no amount has been grandfathered, thus the full excise tax of 15% will apply. *First Vice President, Prudential Securities. Prudential Securities is not a financial or legal advisor. Reprint requests to: Mr. Thomas B. Kret, First Vice President, Prudential Securities, 1900 E. Golf Rd., Suite 1270, Schaumburg, IL 60173. Copyright 9 1996 by the American Association of Orthodontists. 0889-5406/96/$5.00 + 0 8/8/76305
Portion qualified plan subject to tax: Net tax:
18% 3%
Qualified plan included in estate: Less excess accumulation tax: Base for tax: Estate tax rate: Net tax:
100% 2.6%
Payment subject to income tax: Less deduction for estate tax: Base for tax: Income tax rate: Net tax:
100% 45% 55% 39%
47% 45%
21%
It is a hard pill to swallow when that which took a lifetime to build is suddenly and dramatically diminished by taxes. Giving your funds away to charity is one solution, however, most people wish to pass most of their assets on to their heirs. A further consideration are the effects of inflation and overall growth of your assets over time. If your estate is smaller than the example provided, you may still face a significant tax problem. Consequently, you may not have this problem today, however, it could become a significant problem for you in the future.
SUMMARY After seeing all the taxes imposed on qualified plan distributions, a qualified plan with a large asset base can appear to be a lemon. With creative planning, qualified plan assets can be turned into lemonade for both the individual owner of the assets, and his or her heirs. If you are concerned whether you may face the triple tax threat with your qualified plan, and believe it would be appropriate to seek additional information on various strategies to alleviate this problem, you should contact your estate planner or somone with specific expertise in this area.
American Journal of Orthodontics and Dentofacial Orthopedics/September 1996
335
Unpleasant surprise/Tax deferred funds may face triple tax threat Thomas B. Kret* Schaumburg, Ill.
Our whole lifetime we are told to start saving early for retirement, and the best place is through a qualified plan (IRS, 401(k), TSA, Pension, Profit Sharing). Where else can you accumulate money on a pretax-tax basis, have it grow tax-deferred, and, in some cases, receive favorable tax treatment when you take it out at retirement age? This is the standard advice we all receive. What you typically do not hear is that if you are successful in accumulating large sums of tax-deferred assets, you face a triple tax threat when your estate passes from one generation to the next. The triple stands for the three separate taxes that potentially apply to qualified plan distributions: 1. Federal Income Taxes Deferred assets do not receive a step up in basis; consequently, the heirs must pay income taxes when the funds are distributed. If the assets are all distributed in 1 year, this may cause income tax at the highest marginal income tax bracket of 39.6%. 2. Federal Estate Taxes Large estates may be taxed at the highest estate tax rate of 55%; a large qualified plan distribution may push the estate into that bracket. 3. Excess Accumulations Tax Lastly, there may be an excise tax of 15% on the portion of the distribution that is determined to be an excess accumulation. The chart below is an example of the potential qualified plans shrinkage based on a pension of $1,500,000 in a taxable estate of $3,500,000, and death occurring when a person is 58 years old at a time when the Applicable Federal Mid-Term Rate is 8%. We further assume that no amount has been grandfathered, thus the full excise tax of 15% will apply. *First Vice President, Prudential Securities. Prudential Securities is not a financial or legal advisor. Reprint requests to: Mr. Thomas B. Kret, First Vice President, Prudential Securities, 1900 E. Golf Rd., Suite 1270, Schaumburg, IL 60173. Copyright 9 1996 by the American Association of Orthodontists. 0889-5406/96/$5.00 + 0 8/8/76305
Portion qualified plan subject to tax: Net tax:
18% 3%
Qualified plan included in estate: Less excess accumulation tax: Base for tax: Estate tax rate: Net tax:
100% 2.6%
Payment subject to income tax: Less deduction for estate tax: Base for tax: Income tax rate: Net tax:
100% 45% 55% 39%
47% 45%
21%
It is a hard pill to swallow when that which took a lifetime to build is suddenly and dramatically diminished by taxes. Giving your funds away to charity is one solution, however, most people wish to pass most of their assets on to their heirs. A further consideration are the effects of inflation and overall growth of your assets over time. If your estate is smaller than the example provided, you may still face a significant tax problem. Consequently, you may not have this problem today, however, it could become a significant problem for you in the future.
SUMMARY After seeing all the taxes imposed on qualified plan distributions, a qualified plan with a large asset base can appear to be a lemon. With creative planning, qualified plan assets can be turned into lemonade for both the individual owner of the assets, and his or her heirs. If you are concerned whether you may face the triple tax threat with your qualified plan, and believe it would be appropriate to seek additional information on various strategies to alleviate this problem, you should contact your estate planner or somone with specific expertise in this area.
American Journal of Orthodontics and Dentofacial Orthopedics/September 1996
335