ESTATE PLANNING FOR
RETIREMENT BENEFITS
Gerald H. Hansen
Law 7 21
Professor Quilliam
00151
INTRODUCTION
A number of factors must be taken into account when planning
for retirement benefits.
The tax rules governing retirement
plans should be a significant part of proper planning.
From a tax point of view, current income taxes as well as
future income taxes and future estate taxes must be considered.
These factors bear on which type of plan, if any, should be set up and
the method in which distributions from the plan should be made.
A major goal of planning for retirement benefits is to
accumulate funds in an amount sufficient to see the retiree
through his retirement years.
That goal will be achieved much
more readily if, through proper planning, income and estate
taxes are minimized as effectively as possible.
The funds needed during the retirement years can be provided
through either an income stream or through the invasion of principal or both.
Preferably, the income stream will suffice to
meet all needs without the necessity of an invasion of principal.
Furthermore, the income stream should be protected against
inflation.
Otherwise, principal will have to be invaded to
replace the lost purchasing power of a fixed income stream as
it is eroded by inflation."''
This paper will discuss various aspects of self-employed
retirement plans, simplified employee pensions, and individual
retirement accounts, with particular emphasis on the latter.
1.
This
See Kopple & Lawson, Tax Planning for Retirement, 4 0 Inst, on
Fed. Tax'n § 29.01, at 29-3 (1982).
00152
paper will also focus on the opportunities available through
rollovers and exclusions from the estate.
SELF-EMPLOYED RETIREMENT PLANS
The Tax Equity and Fiscal Responsibility Act of 1982
2
(TEFRA)
generally eliminates distinctions in the tax law between
qualified pension plans and those of self-employed individuals.
A qualified plan which benefits a self-employed individual is
generally referred to as a Keogh plan.
Under the Internal Revenue
Code,^ such a plan is subject to the same rules governing the
qualification of other pension plans and, in addition, it is
4
subject to special rules pertinent to self-employed individuals.
In order to be qualified, a Keogh plan which provides benefits for any owner-employee who controls (a sole-proprietor or
a partner owning more than 50 percent
in either the capital
interest or the profits interest) 5 any trade or business must
2.
In general, the changes made by the Tax Equity and Fiscal
Responsibility Act of 1982 relative to retirement benefits
are effective for taxable years beginning after December
31, 1983.
3.
Unless otherwise stated herein, all references and citations
to the Internal Revenue Code (or Code) are to the Internal
Revenue Code of 19 54 as amended by the Tax Equity and Fiscal
Responsibility Act of 1982.
4.
See I.R.C. § 401(a) (10), (c) , (d); Treas. Reg. § 1.401-10 (a) (1
See generally Appel & Stansbury, Employee Benefit Provisions
of the Economic Recovery Tax Act of 1981, 32 Case W. Res. L.
Rev. 628, 661-673 (1982).
5.
I.R.C. § 401(d) (1) (B) .
00153
include the employees of such trade or business and must provide
benefits and contributions for such employees which are not less
favorable than contributions and benefits provided for owneremployees under the plan.^
An owner-employee is an employee
who owns the entire interest in an unincorporated business or
a partner
owning
more
than 10 percent of either the capital
interest or the profits interest.7
Under TEFRA, the general rules governing deductions under
section 404 and contributions and benefits under section 415
will govern Keogh plans.
Accordingly, the deduction to defined
contribution plans is limited to the lesser of $30,000 or 25
g
percent of the participant's compensation.
For taxable years
prior to 1984, the deductible limit is the lesser of $15,000 or
9
15 percent of earned income.
The Code provides that payment of an employee's entire
interest under all types of qualified plans must be distributed
not later than the last day of such employee's taxable year in
which he retires or, if later, the taxable year in which he attains
6.
I.R.C. § 401(d)(2).
7.
I.R.C. § 401 (c) (3) .
8.
I.R.C. § 415(c)(1). See S. Rep. No. 949, 97th Cong., 2d
Sess. 314-317 (1982); S. RepT No.~5 30, 97th Cong., 2d Sess.
618-623 (1982). See also"~Appel & Stansbury, supra note 4,
at 661 n.154.
9.
I.R.C. § 404(e)(1). This citation is to the Internal Revenue
Code prior to its amendment by TEFRA. TEFRA repealed
§ 404 (e).
00154
age seventy and one-half (distribution to owner-employees must
be made by the end of the taxable year in which such employee
attains age seventy and one-half). 10
Alternatively, the plan
may provide for distribution of each employee's entire interest
to commence not later than the taxable year in which such employe<
either attains age seventy and one-half or retires and for such
distribution to continue over the lives of such employee and
his spouse, or over a period not extending beyond either the
life expectancy of such
employee or the life expectancy of such
employee and his spouse.1"'"
Also, the plan must provide that, if an employee dies
prior to receiving his entire interest, his entire interest will
12
be distributed within five years after his death;
however, if
distribution of such employee's interest has commenced for a
term certain over a period not extending beyond either the life
expectancy of such employee or the life expectancy of such
employee and his spouse, the five year limitation above will not
apply and such employee's interest may continue to be distributed
over the term certain.
The same rules apply in a case in which
distribution has commenced to the employee's surviving spouse and
such surviving spouse dies before receiving
. 13
interest.
10.
the employee's entire
11.
I.R.C. § 401(a)(9)(A). See generally Luepker, Qualified
Retirement Plans: Opportunities and Obligations under the
Tax Equity and Fiscal Responsibility Act of 1982, 64 Chi. B.
Rev. 74 , 82 (1982).
=
I.R.C. § 401 (a) (9) (A) (ii) .
12.
I.R.C. § 401 (a) (9) (B) .
13.
Id.
001,15
4
SIMPLIFIED EMPLOYEE PENSION PLAN
In essence, a simplified employee pension plan (SEP) is an
individual retirement account to which both the employer and the
employee make deductible contributions.
To qualify, the
employer must contribute to the SEP of each employee who has
attained age twenty-five and who has been an employee for such
employer during at least three of the five immediately preceeding
calendar years.
In any calendar year, contributions made by the employer
to SEPs may not discriminate in favor of any employee who is:
15
an officer; a shareholder;
a self-employed individual; or
16
highly compensated.
Employer contributions will be considered
discriminatory unless such contributions bear a uniform relationship to the total compensation of each employee participating in
a SEP. 1 7
An employer may not condition its contributions to a SEP
on a provision mandating retention in such pension of any amount
contributed; 18 moreover, an employer may not impose a condition
19
which prohibits withdrawals from the SEP.
14.
I.R.C. § 408 (k) (2) .
15.
A shareholder is an individual owning more than 10 percent
of the value of the stock of the employer. I.R.C. § 408
(k) (3) (B) (ii) .
16.
I.R.C. § 408 (k) (3) (A) .
17.
18.
I.R.C. § 408(k)(3)(C). Only the first $200,000 in compensation is to be taken into account.
I.R.C. § 408 (k) (4) (A) .
19.
I.R.C. & 408 (k) (4) (B) .
00156
The employer is allowed a deduction for contributions to
a SEP.
20
The allowable deduction cannot exceed 15 percent of
the compensation paid to the employee during the calendar year
ending with or within the taxable year. 2 1
An employee must include in his gross income the amount of
22
any contribution made on his behalf by his employer.
In turn,
the employee is allowed a deduction in an amount equal to the
lesser of the amount contributed to the SEP by the employer (but
not in excess of $15,000) or 23
15 percent of the compensation
received from such employer.
The percentage is applied to the
amount of compensation received from the employer and includible
in gross income for the taxable year before such compensation has
been increased by the amount of the employer contributions to
the SEP includible in gross income pursuant to section 219(f) (5).
An employee for whom an employer makes contributions to a
SEP is considered an active plan participant and is allowed a
deduction for his own individual retirement account contributions ($2,000 maximum) as well as a deduction for employer
20.
I.R.C. § 404(h)(1).
21.
I.R.C. § 404 (h) (1) (C) .
22.
I.R.C. § 219(f)(5). The employer contributions are
includible in the employee's gross income whether or not
the employee is entitled to a deduction for such contributions .
23.
I.R.C. § 219(b) (2) (A) .
6
00157
contributions to a SEP on behalf of such employee ($15,000
24
maximum).
This means that an employee who participates in a
SEP has a potential maximum deduction of $17,000 per year.
25
INDIVIDUAL RETIREMENT ACCOUNTS
The Economic Recovery Tax Act of 1981 made significant
changes in the tax laws governing individual retirement accounts
(IRA).
The Act made IRAs more attractive by increasing the amount
which individuals may contribute to an IRA ($2,000 maximum).
In
addition, the Act made IRAs a viable retirement vehicle for
millions of persons who had not previously been eligible for IRA
participation by reason of their participation in employer-sponsored plans.
After the Act, all persons who earn compensation
are eligible to set up an IRA regardless of their participation
in employer-sponsored plans.
One of the major reasons for the changes in the laws relative
to IRAs was Congress' concern that the resources available to
individuals who retire are often not adequate to avoid a signi26
ficant decrease from pre-retirement living standards.
Congress
felt that retirement savings could make an important contribution
24.
I.R.C. § 219(a), (b)(l)-(2).
25.
S. Rep. No. 144, 97th Cong., 1st Sess. 113 (1981). It
should be remembered that $15,0 00 of the deduction is
attributable to employer contributions required to be
included in the employee's income. I.R.C. § 219(b)(A),
(f) (5) .
26
-
s
See I.R.C. § 408 (j) .
- Rep. No. 144, 97th Cong., 1st Sess. 112-113 (1981).
0§J.58
toward maintaining pre-retirement living standards.
The changes
were designed to promote greater retirement savings by providing
27
an incentive to increase savings through retirement plans.
As we shall see infra, IRAs can provide significant advantages
(and therefore should provide significant incentives for retirement savings through the medium of an IRA) over other more mundane
investment alternatives by virtue of their ability to defer taxes
for extended periods of time and their ability to provide a vehicle
for tax-free accumulation of income.
An IRA is a trust created for the benefit of an individual
or his beneficiaries.
The governing instrument
2 8 must be in writing
and it must contain the following provisions:
(1)
All contributions must be in cash and no contribution
in excess of $2,000 will be accepted for any one taxable year on
behalf of any one individual (except that qualifying rollover
contributions in excess of $2,000 will be accepted and, in the
case of a SEP, no contribution
in excess of $17,000 will be accepted
29
for any one taxable year
(2)
);
The trustee must be a bank (defined in section 408(n))
or such other person who satisfies the Secretary that he will
administer the trust in a manner which comports with Section 408 ;
27.
Id.
28.
I.R.C. § 408(a).
29.
I.R.C. § 408 (j) .
00159
8
(3)
No trust funds will be invested in life insurance
contracts;
(4)
The individual's interest in his account is nonfor-
feitable;
(5)
Trust assets will not be commingled with other property
unless pursuant to a common trust fund or a common investment
fund;
(6)
The entire interest of the beneficiary of the trust
will be distributed to him no later than the last day of the
taxable year in which he attains age seventy and one-half or,
alternatively, such entire interest will commence distribution
before the last day of such taxable year over any one of the
following periods:
(1) the life of the beneficiary; (2) the
lives of the beneficiary and his spouse; (3) a period no longer
than the life expectancy of the beneficiary; or (4) a period no
longer than the life expectancy of the beneficiary and his spouse;
(7)
If the beneficiary dies before receiving his entire
interest or if distribution has commenced as provided in (6)
above to such beneficiary's surviving spouse and such surviving
spouse dies before receiving the beneficiary's entire interest,
the entire interest (or any remaining portion thereof) will be
distributed within five years after such beneficiary's death
(or the death of such beneficiary's surviving spouse).
This
"within five" year provision does not apply if, prior to the
beneficiary's death, distribution had commenced for a term certain
over a period permitted in (6) above.
In such a case, distribu-
tion need not be completed within five years; rather, it may continue over the term certain.
If the trust setting up the IRA meets the above requirements,
an individual may make contributions to the IRA and deduct a
maximum of $2,000 or, if less, an amount equal to such individual's
compensation for the taxable year."^
31
from gross income;
The amount is deductible
therefore, an individual may deduct IRA con-
tributions whether such individual itemizes his deductions or
not.
Contributions made up to and including the day on which
the individual's return is legally due (including extensions)
are deductible in the preceding taxable year (e.g. an IRA may be
set up and a $2,000 contribution made on April 15, 1984 and a 32
$2,000 deduction will be available for the 1983 taxable year).
30.
I.R.C. § 219(b)(1). Individuals who are employees participating in a qualified employer plan may, under certain conditions, make qualified voluntary employee contributions to the
employer plan. If the individual-employee does make qualified voluntary employee contributions, the individual is
still eligible to make deductible contributions to his IRA;
however, the deduction for IRA contributions is limited to
a maximum of $2,000 minus the amount of qualified voluntary
employee contributions. I.R.C. § 219(b)(3), (e). For a
more detailed analysis of qualified voluntary employee contributions see infra notes 78-89 and accompanying text.
31.
I.R.C. § 62 (10) .
32.
I.R.C. § 219(f) (3) (A) .
10
If an individual is contemplating setting up an IRA and does
not have the cash to contribute by April 15 but expects to have
the cash soon, it may be wise to file form 4868 for an automatic
extension.
In this way, a contribution may be made by the due
date of the return as extended and still qualify for a deduction
in the preceding taxable year.
The Code places certain limitations on deductions.
No deduc-
tion is allowed for a qualified retirement contribution 33 unless
the beneficiary is under age seventy and one-half at the close
34
of the taxable year.
No deduction is allowed for any amount
35
paid to an inherited IRA.
(This provision was added by TEFRA
and is effective for taxable years ending after December 31, 1983)
Married individuals may both contribute and deduct $2,000
($4,000 total) to their own IRAs provided both
spouses work and
36
have at least $2,000 each in compensation.
For married individuals with only one working spouse, the
working spouse may set up a "spousal IRA" for the benefit of the
33.
A qualified retirement contribution is any qualified
voluntary employee contribution paid in cash to an employer
plan, and any amount paid in cash to an IRA by or on behalf
of the beneficiary. I.R.C. § 219(e)(1).
34.
I.R.C. § 219(d) (1) .
35.
I.R.C. § 219(d)(4). An inherited account is one which the
owner acquires by reason of surviving the death of another
individual and such owner was not the surviving spouse of
such other individual. I.R.C. § 408(d)(3)(C)(ii).
36.
I.R.C. § 219(f) (2) .
11
nonworking spouse.
A deduction is available only if a joint
return is filed and only if one spouse has no compensation for
the taxable year.
37
The deduction is limited to a maximum of
$2,250 or, if less, the amount of compensation includible in
38
the working spouse's gross income for the taxable year.
The Code permits flexibility in the method used for allocation of the contributions between spouses.
Contributions may
be allocated between the two accounts in any manner desired so
long as the amount allocated to either the working spouse's
account or the nonworking spouse's account does not exceed
39
$2,000.
For example, H works and receives $30,000 in compen-
sation for the taxable year.
the taxable year.
H's wife W has no compensation for
H may set up his own IRA and he may set up a
spousal IRA for the benefit of W.
$2,250 to the two accounts.
H may contribute a maximum of
H may allocate a maximum of $2,000
to either his IRA or W*s spousal IRA.
Alternatively, H may
allocate $1,250 to his IRA and $1,000 to W's account, or H may
allocate any amount to either account provided such amount does
37.
I.R.C. § 219(c) (1). Under the rules pertaining to spousal
IRAs, community property laws are disregarded. This means
that one spouse is not considered to have compensation just
because the other spouse does and they live in a community
property jurisdiction. I.R.C. § 219(f) (2).
38.
I.R.C. § 219(c) (2). The $2,250 is reduced by the amount
deducted for contributions to the working spouse's own IRA.
39.
Id. See Kulsrud, Individual Retirement Accounts: A Close
Examination of the Opportunities, 60 Taxes 83, 84 (1982).
12
00163
not exceed $2,000.
Also, it appears that an individual who has
reached seventy and one-half and is, therefore, ineligible to
make deductible contributions to his own IRA 40 may continue to
make contributions to the spousal IRA as long as the nonworking
41
spouse has not attained age seventy and one-half.
In the case of a nonworking divorced spouse, a special provision applies.
A divorced taxpayer whose former spouse established,
at least five years before the beginning of the year in which the
divorce occurred, a spousal IRA for the taxpayer's benefit and
made deductible contributions to such account for at least three
of those five years is eligible
42 to continue making deductible
contributions to the account.
The amount of the deductible
contribution is limited to the lesser of $1,125 or the sum of the
taxpayer's compensation
and the amount of taxable alimony received
43
by the taxpayer.
Section 219(b)(4) does not appear to limit
the taxpayer's ability to continue such contributions even though
he or she remarries.
40.
See supra note 34 and accompanying text.
41.
I.R.C. § 219(d)(1) speaks in terms of "contribution for the
benefit of an individual" and, therefore, appears to authorize
deductions for contributions made on behalf of a nonworking
spouse who is under seventy and one-half even though the
working spouse is over seventy and one-half.
42.
I.R.C. § 219(b) (4).
43.
Id.
13
00164
Section 408(d)(6) allows the ownership of an IRA to be
transferred tax-free to a former spouse pursuant to a divorce
decree.
In essence, this rule allows an individual who has been
deducting contributions to an IRA to have prepaid and pre-deducted
his alimony liability or to have received the benefit of a tax
deduction for what would otherwise be a nondeductible property
44
settlement.
This may be an important planning device for a
taxpayer when negotiating a divorce settlement.
Income earned by an IRA is exempt from tax until distributed
unless the beneficiary engages in a transaction prohibited by
section 4975 (or the owner of an individual retirement
annuity
45
borrows money under or by use of the annuity).
Tax-exempt
status permits a tax-free accumulation of funds while such funds
remain in the account.
If the owner or his beneficiary engages in any prohibited
transaction (as defined in section 4975),, the IRA will become disqualified, and it will, henceforth, cease to be an IRA as of the
44.
Carlson & Schmid, IRA rollovers can defer income taxes and,
with a trust beneficiary, save estate taxes, 7 Est. Plan.
332 (1980).
45.
I.R.C. § 408(e). This tax exempt status does not apply to
any unrelated business income of the IRA. If an IRA has
unrelated business income, the tax imposed under I.R.C.
§ 511 is applicable. See I.R.C. §§ 408(e)(1), 511(a).
Unrelated business income is essentially income derived
from the conduct of activities which are not substantially
related to the exercise of the functions for which the IRA
is allowed exemption from tax. See I.R.C. §§ 512(a)(1),
513(a).
00 J 65
first day of the taxable year in which the prohibited transac46
tion occurs.
In addition, the owner is treated as if he
received, on the first day of such taxable year, a distribution
from the account in an amount equal to the fair market value of
all assets in the account on such first day. 47 This distribution
is included in the owner's gross income for the taxable year and
48
is fully taxable.
Moreover, if the owner has not attained
age fifty-nine and one-half before the first day of the taxable
year in which the disqualification of the IRA occurs, the distribution is considered pre-mature and, accordingly, increases such
owner's tax (not income) by 10 percent of the
49 amount deemed distributed by virtue of section 408(e)(2)(B).
However, the five
percent and one-hundred percent excise taxes imposed under section
50
4975 will not be imposed under these circumstances.
If the beneficiary of an IRA uses the account or any portion
of it as security for a loan, the portion so used is treated as
a distribution to the beneficiary.^1
Accordingly, if the bene-
ciary has not attained age fifty-nine and one-half at the time
46.
I.R.C. § 408(e)(2)(A).
see I.R.C. § 4975(c).
47.
I.R.C. § 408 (e) (2) (B) .
48.
I.R.C. § 408(d)(1).
49.
I.R.C. § 408 (f) (2) .
50.
I.R.C. § 4975 (c) (3) .
51.
I.R.C. § 408(e) (4).
For a list of prohibited transactions,
00166
he pledges the account, his tax will be increased by 10 percent
52
of the amount deemed distributed.
Pledging, however, does not
affect the tax-exempt status of the IRA nor does pledging disqualify the IRA.
Excess contributions to an IRA are subject to a six percent
53
excise tax.
An excess contribution is determined by taking
the excess of the amount contributed for the taxable year (exclusive of qualified roll over amounts) over the amount allowable
as a deduction under section 219 and adding to that figure the
excess contributions for the preceding taxable year reduced by
the sum of:
(1) distributions out of the IRA for the taxable year
which were included in gross income under section 408(d)(1); (2)
distributions of excess contributions after the due date of the
return (determined under section 408(d)(5)); and (3) excess (if
any) of the maximum amount allowable as a deduction under section
219 for the taxable year over the amount contributed for such
54
taxable year.
The excess contribution excise tax (six percent of the excess
contribution) is imposed for the taxable year in which the excess
contribution is made and, thereafter, for every year in which an
52.
I.R.C. § 408 (f) (2) .
53.
I.R.C. § 4973 (a) .
54.
I.R.C. § 4973(b).
0$S7
18
excess contribution remains in the IRA
an exception.
The excess contribution tax will not be applied
if three conditions are met:
(1)
However, there is
56
if the excess contribution is returned on or before
the due date of the individual's return (including extensions);
(2)
if no deduction is allowed under section 219 with
respect to such excess contribution; and
(3)
if any earnings attributable to the excess contribution
are returned along with such excess contribution.
Section 408(d)(4) also provides that, for purposes of gross income,
any amount of earnings attributable to the excess contribution
and withdrawn in accordance with section 408(d)(4)(C) will be
deemed to have been earned and received in the taxable year in
which such excess contribution is made.
For example, if A con-
tributes $10,000 to his IRA on December 1, 1983, he has made an
excess contribution.
Assume that on April 1, 1984, A withdraws
55.
I.R.C. § 4973(a)(3). The 6 percent excise tax on excess contributions is limited. It will never exceed 6 percent of the
value, as of the close of the taxable year, of the IRA. See id.
56.
I.R.C. §§ 408(d)(4), 4973(b). This result is reached by
applying the provisions of § 408(d)(4) in conjunction with the
last sentence of § 4973(b) which provides that "For purposes
of this subsection, any contribution which is distributed
from the individual retirement account, . . ., in a distribution to which section 408(d)(4) applies shall be treated as
an amount not contributed." Therefore, in calculating the
amount of an excess contribution under § 4973(b), any contribution which is withdrawn in accordance with the provisions
of § 408 (d) (4) is deemed not to have been a contribution and,
consequently, such contribution never enters the calculation
of excess contributions.
17
the excess contribution and earnings attributable thereto.
Assume
that the income attributable to the excess contribution of $8,000
is $300 ($250 of which was earned after December 31, 1983).
$300 of income is includible in A's gross income for 1983.
All
This
would be true even if A had originally made the excess contribution
57
in 1984 prior to the due date of his return.
If an individual makes an excess contribution and does not
withdraw it in accordance with section 408(d)(4), such individual
will be liable for the six percent tax on excess contributions.
The six percent tax on excess contributions
applies for every year
58
such excess remains in the IRA.
tax may
In subsequent years, the excise
be avoided if such excess is withdrawn from the IRA.
Moreover, tax on the distribution (withdrawal), in subsequent
years, of the excess contribution may be avoided if the total
contribution made to the IRA did not exceed $2,250 and no deduction
59
was allowed under section 219 with respect to such excess contribution.
57.
Under I.R.C. § 219(f)(3), contributions made after the end
of the taxable year but prior to the due date for filing a
return are deemed to have been made in the preceding taxable
year.
58.
I.R.C. § 4973(a).
59.
I.R.C. § 408(d)(5)(A). If the excess contribution was attributable to an excess rollover contribution made in reliance
upon information supplied pursuant to I.R.C. §§ 6057-6059
and such information was erroneous, then the $2,250 limitation in I.R.C. § 408(d)(5)(A) will be increased by the portion of the excess contribution which was attributable to
such erroneous information. I.R.C. § 408(d)(5)(B).
10
Finally, if the amount contributed to an IRA in a taxable
year is less than the maximum amount allowable as a deduction
under section 219 for such year and the account contains excess
contributions from prior taxable years, then the individual will
be treated as having made an additional contribution for the
taxable y e a r . ^
In such cases, the individual will be treated
as if he contributed an additional amount equal to the "deficiency"
contribution for the taxable year or, if less, the amount of the
excess contributions for such taxable year.
The benefits available through an IRA depend on several
variables.
The amount of funds invested, the frequency of invest-
ments, the period of time over which the funds will remain in the
account, the rate of return available, and the individual's incremental (or marginal)^1 tax rate are all factors that must be
considered.
One of the advantages of an IRA is the ability to
obtain current tax deductions in earning years when the individual
is usually in a higher incremental tax bracket; withdrawals are
then made during the retirement years when the individual's incremental tax rate is generally lower; but, even if the individual's
incremental tax rate remains the same, an IRA is still a good
investment.
60.
I.R.C. § 219(f) (6) .
61.
An individual's incremental (or marginal) tax rate is
simply the rate at which any additional income earned by
the individual will be taxed.
37
00170
The real keys to an IRA are the current tax deductions for
contributions and the deferral of tax on income earned on the
contributions while the funds remain in the account.
The IRA
is able to earn a full pre-tax rate of return, while deferring
all taxes until distributions occur.
As the individual's incre-
mental income tax rate increases and as the rate of return
available to such individual increases, the benefits of an IRA
investment increase.
The opportunities available through the vehicle of an IRA
as an investment tool relative to the opportunities available
through non-IRA investments can be analyzed by a monetary comparison between the results obtained from IRA investments versus
non-IRA investments.
used to compare
62
A mathematical model can be set up and
saving pre-tax
dollars
through an IRA versus
63
saving after-tax dollars outside an IRA.
The variables will
64
be identified and labeled as follows:
62.
See Bristol, Individual Retirement Accounts: A Good Investment?,
14 Tax Notes 507 (1982); Coppage, IRA: an offer you can't
refuse?7 13 Tax Adviser 674 (1982); Kulsrud, supra note 39,
at 86-89.
~
63.
See Coppage, supra note 62, at 674-75.
64.
Id
10
IRA
[I-.IOI-(T)(I)]Srn
I
T
Srn
=
=
=
Stn
=
Non-IRA
[(I)(1-T)]Stn
the potential investment
the incremental tax rate
the future value of a sum of money
at (r) rate of return (pre-tax) for
(n) number of periods
the future value of a sum of money
at (t) rate of return (after-tax)
for (n) number of periods
The "IRA" model includes the ten percent penalty tax on early
65
withdrawals;
the model, therefore, represents the worst possible
situation wherein an individual must withdraw the funds prior to
attaining age fifty-nine and one-half.
For example, assume that
A has $2,000 to invest and wants advice on whether to establish
an IRA.
A is fifty years old, will need the money five years from
now, and has a thirty-three percent incremental tax r a t e . ^
A
anticipates a before tax rate of return of twelve percent.
The
variables to be plugged into the formula are as follows:
I
=
$2,000
T
=
33%
Srn
=
1.762 (before tax rate of return)
Stn
=
1.469 (after tax rate of return)
IRA
[$2,000 - (.10) ($2,000) - .33 ($2,000)] (1.762)
($2,000 - $200 - $660) (1.762)
$2,008.68
Non-IRA
[ ($2,000) (1 - .33) [ (1.469)
[($2,000) (.67)] (1.469)
$1, 968 .46
65.
See I.R.C. § 408(f)(1).
66.
The hypothetical tax rate is based on the incremental tax rate
for married individuals filing a joint return with taxable income between $35,200 and $45,800 for taxable years beginning
after 1983. See I.R.C. § 1(a)(3).
00172
21
Under the above analysis, A would be better off setting up
an IRA..
This is true even though he will be required to pay the
ten percent tax on early distributions.
If A were to leave the
funds in the IRA for ten years and thereby avoid the ten percent
penalty, the advantages of the IRA increase:
IRA
[$2,000 - .33($2,000)] (3.106)
($2,000 - 660) (3.106)
$4,162.04
Non-IRA
[ ($2,000) (1 - . 33)] (2.240)
($1,340) (2,240)
$3,001.60
The advantages of an IRA investment versus a non-IRA investment over varying lengths of investments assuming a twelve percent
rate of return, a thirty-three percent incremental tax rate, a
$2,000 initial investment, and a ten percent penalty on early
distribution are represented below.
*IRA after
Non-IRA
Years
tax & penalty
after tax
Advantage (Dis
of IRA over
1
$1,277
$1,447
2
1,430
1,562
($170)
( 132)
3
1,602
1,688
(
86)
4
1,794
1,824
(
30)
5
2,009
1,968
41
10
3,541
2,893
648
20
10,996
6,246
4, 750
*All figures in this table and the tables that follow have been
rounded.
The breakeven point is between years four and five.
Note
that the higher the incremental tax rate, the greater the advantage
00134
in favor of an IRA.
With the increased savings, the number of
years required to benefit from an IRA decreases as the tax rate
67
increases.
Holding steady the number of years at five, the rate
of return at twelve percent, and the investment at $2,000, the
tax rate can be varied to determine its affect on the respective
investments.
Incremental
tax rate
IRA after
tax & penalty
Non-IRA
after tax
Advantage
(Disadvantage) of
IRA over non-IRA
18%
$2,537
$2,622
25%
2,291
2,309
( 18)
33%
2,009
1,968
41
45%
1,586
1,515
71
50%
1,410
1,338
72
($85)
This illustrates that the higher the incremental tax rate the
better the advantage in favor of an IRA.
Now we can vary the rate of return to determine its affect on
the respective investments.
The number of years will be held
steady at five, the incremental tax rate will be held steady at
thirty-three percent, and the investment will be held steady at
$2,000.
As will be seen, as the rate of return increases, the
amount of income available for tax-free accumulation increases,
thereby increasing the advantage of an IRA investment.
67.
See, Bristol, supra note 62, at 507-508; Coppage, supra
note 62, at 675.
Before tax
rate of return
IRA after
tax & penalty
Non-IRA
after tax
Advantage
(Disadvantage) of
IRA over Non-IRA
6%
$1,525
$1,632
8%
1,675
1,739
( 64)
10%
1,837
1,853
12%
2,009
1,968
( 16)
41
14%
2,195
2,098
97
16%
2,394
2,230
164
18%
2,608
2,368
240
20%
2,836
2,513
323
($107)
The above illustrations view the investment as a one-time investment.
Typically, the individual who sets up an IRA will invest
some money each year.
Assume that A contemplates having $2,000
per year to invest, is in a thirty-three percent incremental tax
rate, will be able to earn twelve percent (before taxes), and
will need to withdraw the funds before attaining age fifty-nine
and one-half.
The following table will compare the IRA investment
versus the non-IRA investment over various years under the assump.68
tions stated herein.
Year
1
2
3
4
5
$1,277
2,706
4,308
6,102
8,111
6
10,361
7
12,882
8
15,705
18,865
22,407
91,997
308,133
9
10
20
30
68.
IRA after
tax & penalty
Non-IRA
after tax
$1,447
3,010
4,698
6,522
8,490
10,617
12,914
15,394
18,073
20,966
66,227
163,943
Advantage (Disadvantage)
of IRA over non-IRA
($170)
( 304)
390)
420)
379)
256)
32)
311
793
1,441
25,770
144 ,190
The calculations are based on the future amount of an annual
ordinary annuity. An ordinary annuity is an annuity invested at
the beginning of each year. Conversely, an annuity due (or an
annuity in arrears) is an annuity invested at the end of each
OA
00175
As can be seen from this example, the breakeven point is between
years seven and eight, while in the case of a single deposit the
breakeven point was between years four and five.
The reason for
this is that the penalty tax takes a larger "bite" in the annual
annuity case because at any given time more of the money in the
IRA is "new" money —
money which has been recently put in -- and
the "new" money has not had the time to compound to a higher
rate of return. 69
Note, that none of the above calculations included any initial
charges for opening an IRA or any annual charges that may be
assessed by the trustee for maintenance of the account.
These
costs will also have to be considered when analyzing an IRA investment.
Also, the calculations did not consider the affects of
inflation.
In the first table (where the initial cash investment
of $2,000 grew to $10,996.44
after twenty years), if, during this
twenty year period, inflation were at a constant rate of eight
percent, that $10,996.44 would only purchase what $1,088.65 would
purchase in year one.
With respect to the non-IRA investment,
the $6,245.74 would be worth only $618.33 in today's dollars.
Therefore, although inflation is a factor to consider in planning
for retirement benefits, it does not alter the attractiveness of
the IRA relative to the non-IRA investment.
69.
See Bristol, supra note 62, at 509.
70.
See id. at 508.
70
The assumptions stated herein assumed a ten percent penalty
tax for early withdrawals.
If an individual is over fifty-nine
and one-half and still working (thereby being eligible to make
deductible contributions), there will be no penalty tax for
withdrawing the funds from the IRA; thus, the IRA will be more
attractive.
In such a case, it may be prudent to use an IRA as
a savings account; all contributions (subject to the deductible
limits under section 219) will be deductible and the depositor
will maintain ready access to the funds without the fear of a
penalty.
However, it must be remembered that no deductions are
allowed for any contributions once the individual has attained
71
age seventy and one-half,
and distributions must begin, in
accordance with the provisions of section 408 (a) (6), at least
by the time the individual attains age seventy and one-half.
Many IRAs, although under the control of a trustee or custodian, are "self-directed" in the sense that the beneficiary is
responsible for directing the trustee or the custodian as to the
investments to be made with the IRA assets.
Accordingly, an
individual should be aware that, under the Code, any investment
in a "collectible" is treated as a distribution (and thus included
in the individual1s income) from the IRA is an amount equal to the
72
cost of the collectible.
A collectible includes:
any work of
art, any rug or antique; any metal or gem; any stamp or coin; any
71.
I.R.C. § 219(d)(1).
72.
I.R.C. § 408(m)(1).
26
alcoholic beverage; or any other tangible personal property that
73
the Secretary designates as a collectible.
In directing investments, an individual will generally derive
the greatest benefit by causing the IRA to invest in assets
which produce ordinary income 74
rather than assets that will
yield long-term capital gain.
This is true for two reasons:
(1) the appreciation on capital gain assets accrue tax-free even
without
the tax exempt status of an IRA; (2) the favorable income
tax treatment on sells or exchanges of capital assets producing
long-term capital gains is lost when IRA assets are sold or
exchanged; 75 the gain or loss on sells of IRA assets is not
76
taxable until such assets are distributed;
when distributed,
all IRA assets are taxed as ordinary income -- long-term capital
gain treatment is not available. 77
QUALIFIED VOLUNTARY EMPLOYEE CONTRIBUTIONS
The Code allows an individual to make deductible qualified
voluntary employee contributions to qualified employer plans.
78
73.
I.R.C. § 408(m)(2).
74.
See Kulsrud, supra note 39, at 90.
75.
See id.
76.
I.R.C. § 408 (e) (1) .
77.
78.
I.R.C. § 408(d)(1).
I.R.C. § 219(a) ,(e) (1). See S. Rep. No. 14 4 , 97th Cong. ,
1st Sess. 113 (1981). See also Appel & Stansbury, supra note
4, at 639-648, Branton & Buniva, Should employers permit
voluntary IRA-type contributions to qualified retirement
plans?, 57 J.- Tax'n 378 (1982); IRA Answers ERTA Questions
on IRAs, DECST Keogh Plans, and Seps, 8 J. Pension Plan.
Compliance 300 (1982).
- -
0178
The types of qualified plans which may accept qualified voluntary
79
employee contributions (QVEC) include:
a qualified plan esta-
blished under section 401(a); a qualified annuity plan established
under section 403(a); a qualified bond purchase plan established
under section 405(a); and plans funded with an annuity contract 8 0
established under section 403(b). To be deductible, a QVEC must:
(1) be voluntary;
81
(2) be made as an employee under a qualified
plan; (3) be to a qualified plan which allows an employee to make
82
QVEC;
and (4) not be designated by the employee as other than
deductible.^
79.
I.R.C. § 219(e)(3).
80.
I.R.C. § 219(e) (2) (A) .
81.
See I.R.C. §§ 219(e) (2) (B) which provides that a voluntary
contribution is any contribution which is not a mandatory
contribution. Mandatory contributions are amounts contributed to the plan by the employee which are required as a
condition of employment, as a condition of plan participation, or as a condition for obtaining benefits under the
plan. I.R.C. § 411(c)(2)(C).
82.
If the plan does not allow QVECs, it must be amended to
allow such contributions before such contributions will be
eligible for a deduction.
83.
An individual will be treated as having designated a contribution as nondeductible if he notifies the plan administrator that such contribution is not to be taken into account
as a deductible voluntary contribution. The notification
will be timely if made not later than April 15 of the
succeeding calendar year or such earlier time as is prescribed by the plan administrator for such notifications.
I.R.C. § 219 (e) (2) (C) .
37
00179
The QVECs are subject to the same deductible limits as are
imposed upon qualified retirement contributions to an IRA (i.e.
lesser of $2,000 or amount of compensation includible in gross
income).
84
Furthermore, the amount of the deduction for QVECs
correspondingly reduces the amount that may be deducted for con85
tributions to an IRA.
in 1984.
For example, A makes a QVEC of $1,500
A does not specifically designate such contribution
as nondeductible (therefore it is deemed to be a deductible
QVEC).
IRA.
A may deduct a maximum of $500 for contributions to an
If A contributes more than $500 to an IRA/ the amount in
excess of $500 will be an excess contribution and, consequently,
will be subject to the six percent excise tax on excess contribu86
tions.
If the plan permits, an employee may make aQVEC up to April 15
and the contribution will
8 7 be deemed to have been made in the
preceding taxable year;
however, if the plan administrator pre-
scribes an earlier date, the QVEC must be made by the earlier 8 8
date in order to be deductible in the preceding taxable year.
From a planning point of view, an employee will maximize the
advantage of tax deferral by designating any QVECs as non-deductible.
84. See I.R.C. § 219(a),(b)(1),(e)(1).
85.
I.R.C. § 219(b)(3).
86.
I.R.C. § 4973(a),(b).
text.
87.
I.R.C. § 219(f) (3) (B) .
88.
Id.
See supra notes 53-60 and accompanying
29 00130
This will allow the employee to contribute the maximum of $2,000
to his IRA. and deduct such amount from his gross income; at the
same time, the earnings on the QVECs will accumulate tax-free
while in the employer plan.
Since the contributions to the IRA
also accumulate tax-free, this will enable more funds to accumulate tax-free than if only $2,000 were contributed and allocated
between the employer plan and the IRA.
QVECs are subject to a penalty for early withdrawal.
If any
accumulated deductible employee contributions are received by the
employee prior to attaining age fifty-nine and one-half (and
such receipt is not attributable to such employee's becoming
disabled), then the employee's tax is increased by an amount
89
equal to ten percent of the amount so received.
DISTRIBUTIONS AND ROLLOVERS
In general, distributions from qualified plans (including Keogh
plans) are taxed in accordance with the annuity rules of section
72.
90
A lump sum distribution from a qualified plan may qualify
for long-term capital gain treatment and the favorable ten year
. .
91
income averaging provisions.
89.
I.R.C. § 72(o)(2).
90.
I.R.C. § 402(a)(1).
91.
I.R.C. § 402(a)(2),(e).
10
The portion of the lump sum distribution that will be treated
as a long-term capital gain will be an amount equal to the portion of the distribution which represents active plan participa92
txon by the employee prior to 1974.
The remainder of the dis-
tribution will be taxed as ordinary income.
On the ordinary
income portion, the recipient 93
may elect the special ten year
forward averaging provisions.
Alternatively, the individual
may elect to forego long-term capital gain treatment on the lumpsum distribution and, instead, elect to treat the entire amount
as ordinary income taxable under the favorable ten year averaging
provisions. 94
It appears that the portion (if any) of the lump
92.
I.R.C. § 402(a)(2). The long-term capital gain portion is
determined by multiplying the lump sum distribution by a
fraction, the numerator of which is the number of calendar
years of active plan participation by the employee prior to
1974, and the denominator of which is the total number of
calendar years of active plan participation by the employee.
With respect to employees other than self-employed individuals, the long-term capital gain treatment automatically
applies, unless they elect otherwise. I.R.C. § 402(a)(2),
(e)(4)(L). However, with respect to self-employed individuals, long-term capital gain treatment will be available
only if an election for the favorable ten year averaging
is made. I.R.C. § 402 (a) (2) .
93.
I.R.C. §
attained
only one
I.R.C. §
94.
I.R.C. § 402(e)(4)(L). The election under this subsection
is irrevocable; consequently, it applies to all lump sum
distributions received by the individual.
402(e)(1), (e)(4)(B). If the individual has
age fifty-nine and one-half, he is entitled to
election of the ten year averaging provisions..
402(e)(4)(B).
31
00182
sum distribution which represents QVECs will not qualify for
the favorable ten year averaging provisions, nor will it
95
qualify for long-term capital gain treatment.
Distributions from an IRA are taxed under the provisions
of section 408(d).
Such distributions are included in gross
income in full and do not qualify for either long-term capital
gain treatment or the favorable ten year averaging provisions
(even though such distributions are in a lump sum).
IRA distri-
butions must begin no later than the taxable year
in which the
96
beneficiary attains age seventy and one-half.
An alternative to immediate taxation of distributions is
provided under the rollover provisions. For qualified plans, a
rollover must meet the following requirements to be effective: 97
95.
See I.R.C. § 402(e)(4)(A) which provides that "for purposes
of this subsection, subsection (a)(2) of this section, . . .
the balance to the credit of the employee does not include
the accumulated deductible employee contributions under
the plan . . . ." See also Appel & Stansbury, supra note 4,
at 648.
96.
I.R.C. § 408(a)(6). Qualified plan distributions have a
similar provision. Distributions must begin not later than
the taxable year in which the employee either attains age
seventy and one-half or, if later, retires.
(Distributions
to owner-employees must begin no later than age seventy and
one-half without regard to when such employee retires.)
I.R.C. § 401(a)(9)(A).
97.
I.R.C. § 402(a)(5). An individual is entitled to rollover
a distribution which meets the requirements of I.R.C. §
402(a)(5) into an IRA after the taxable year in which the
individual attains age seventy and one-half; however, distribution of the entire interest must begin by the close
of that taxable year. See Rev. Rul. 82-153, 1982-35 I.R.B.
6.
1)
The balance to the credit of an employee must be paid
98
to him in a qualifying rollover distribution;
2)
the employee must transfer any portion (i.e. partial
rollovers are permissible)
of the assets received to an eligible
99
retirement plan;
3)
and
the employee must complete the transfer within sixty
days after receiving the distribution.
If the rollover meets the above requirements, the amount distributed to the employee and rolled over will not be includible in
the employee's income.
An employee may not rollover any non-deductible "employee
contributions" included in the distribution. 100
Employee contri-
butions equal the excess of amounts considered contributed by the
98.
A qualifying rollover distribution means one or more distributions within one taxable year of the employee on account
of:
(1) termination of the plan; or (2) complete discontinuance of contributions under a profit-sharing or stock
bonus plan; or a distribution which constitutes a lump sum
distribution. I.R.C. § 402(a)(5)(D). A lump sum distribution is a distribution or payment within one taxable year
of the recipient of the entire balance of the employee's
account which becomes payable to the recipient:
(1) on
account of the employee's death; (2) after the employee
attains age fifty-nine and one-half; (3) on account of the
employee's separation from service; or (4) after the
employee becomes disabled. I.R.C. § 402(e)(4)(A).
99.
An eligible retirement plan means: an IRA; an individual
retirement annuity; a retirement bond; a qualified trust;
and a section 403(a) annuity plan. I.R.C. § 402(a) (5) (D) (iv).
100. I.R.C. § 402 (a) (5) (B) .
33
AfH o 4
employee 101 over any amounts previously distributed to the
employee which were not includible m
his gross income. 102
These
103
nondeductible employee contributions will be received tax-free.
An employee who receives non-cash property may roll it over
into a qualified recipient account.
Since some plan trustees
may not want to manage non-cash assets, a provision is available
which allows the employee to sell the property and roll over
the proceeds.
All proceeds rolled over are tax-free, including
amounts relating to any increase in the fair market
104value of the
property subsequent to the original distribution.
With respect to Keogh plans, the only type of rollover permitted for an owner-employee (self-employed individual) is into
105
an IRA.
Section 402(a)(5)(E)(li) specifically denies rollover
into a qualified plan for self-employed individuals participating
in Keogh plans; moreover, section 408(d)(3)(A)(ii) explicitly
prevents a self-employed individual from re-rolling over, into
a qualified plan, assets from an IRA that received his original
101. I.R.C. § 402(a)(5)(D)(ii)(I). Amounts considered contributed
by the employee are determined in accordance with the provisions of I.R.C. § 72 (f) .
102. I.R.C. § 402(a) (5) (D) (ii) (II) .
103. See I.R.C. § 73 (f) , (d) (1) .
104. I.R.C. § 402(a) (6) (D) (i)-(ii).
105. I.R.C. § 402(a) (5) (E) (ii). See generally Comment, How to
Accomplish Successful Tax-free Pension Plan Rollover, 8
Pepperdine L. Rev. 933, 961 (1981). Common law employees
are eligible to rollover distributions into qualified plans.
00185
rollover from the Keogh plan; 106 consequently, the self-employed
individual will be locked into the IRA once he rolls over assets
from a Keogh plan to the IRA.
107
For a self-employed individual,
these provisions render a rollover from a Keogh plan to an IRA
more restrictive and less advantageous.
The reason is that dis-
tributions from an IRA are not eligible for long-term capital
gain treatment nor are they eligible for the favorable ten year
averaging provision (even though such distributions may be lump
sum distributions).
All distributions from an IRA will be taxable
as ordinary income.
Another restriction facing self-employed individuals relates
to lump sum distributions.
Separation from service will not
108
suffice to generate lump sum distribution under section 402.
To qualify for lump sum distribution a self-employed individual
must: have attained age fifty-nine and one-half; become disabled;
.
, 109
or have died.
106. This means that an individual cannot rollover a distribution
from an IRA to any kind of qualified plan if any part of such
distribution is attributable to a prior rollover contribution
from a Keogh plan and the individual who made the prior rollover was self-employed at the time contributions on his
behalf were made to the original Keogh plan. I.R.C. § 40 8
(d) (3) (A) (ii) .
107. See Comment, supra note 105, at 961 n.190.
108. I.R.C. § 402(e)(4)(A). However, the self-employed individual
may rollover a distribution from a terminated plan even though
the distribution does not qualify as a lump sum distribution.
See I.R.C. § 402(a)(5)(D)(i).
109. Id. Self-employed individuals may avoid the penalty tax, under
I.R.C. § 72(m)(5), on premature distributions from a Keogh plan
and continue to make annual deductible contributions by rolling
over the distribution into a SEP-IRA upon termination of the
Keogh plan. See Grinde, Tax-free rollovers from Keogh plans to
SEP-IRA, 12 Tax Adviser 546 (1981).
Only the employee or the employee1s surviving spouse is
eligible to roll over tax-free a distribution from a qualified
plan. 1 1 0
No other named beneficiary is eligible for tax-free
rollover treatment. 111
IRA.
112
Spousal rollovers must be made into an
The distribution must be received by the spouse on account
113
of the employee's death.
The general rules applicable to roll-
overs by employees apply also to spousal rollovers from qualified
plans.The
rollover must be made within sixty days.11"'
116 Non-
deductible employee contributions may not be rolled over.
The surviving spouse who rolled over a qualifying distribution from a qualified plan to an IRA may not later roll that
distribution out of the IRA and into another qualified plan. 117 This
110. See I.R.C. § 402(a)(5), (7).
111. Id. See Adams, Planning for Retirement Benefits, 121 Tr. & Est.
Sept. 1982 at 12, 14; Comment supra note 105, at 96 3. However,
the recipient of the distribution is eligible for long-term
capital gain treatment and the favorable ten year averaging
provisions as long as the distribution otherwise constitutes
a lump sum distribution. See I.R.C. § 402(e)(4)(A) which
speaks in terms of "recipient" rather than "employee."
112. I.R.C. § 402(a)(7)(A)(ii) requires that the surviving spouse
transfer any portion of the distribution to an IRA. This
provision clearly limits rollover to an IRA; it also authorizes a partial rollover.
113. I .R.C. § 402(a) (7) (A)
114. I .R.C. § 402(a) (7)(B)
115. I .R.C. § 402(a) (5) (C)
116 . I .R.C. § 402(a) (5) (B)
117. I • R.C. § 408(d) (3) (B)
10
prevents the surviving spouse from circumventing the prohibition
on spousal rollovers from one qualified plan to another by rolling
the initial distribution into a "conduit" IRA and later rolling
such distribution out of the IRA and into another qualified plan;
thus, if the surviving spouse were employed by a company with a
qualified plan, she may not rollover the distribution into that
plan.
IRA distributions may be rolled over into another IRA by
118
the owner or his spouse.
An inherited IRA may not be rolled
119
over;
therefore, named beneficiaries other than the surviving
spouse may not rollover distributions received from the IRA.
The of
IRA
rollover
must be
effected
within sixty
days after
120
receipt
the
distribution.
Additionally,
IRA rollovers
are available only one time per year.
121
118. I.R.C. § 408(d) (3) .
119. I.R.C. § 408(d)(3)(C). An
the individual acquired by
person and such individual
such other person. I.R.C.
inherited IRA is one in which
reason of the death of another
was not the surviving spouse of
§ 408(d)(3)(C)(ii).
120. I.R.C. § 408 (d) (3) (A) ,(i) .
121. I.R.C. § 408(d)(3)(B). Cf. Rev. Rul. 78-406, 1978-2 C.B.
157 (said that the transfer of funds from one IRA trustee
directly to another IRA trustee does not constitute a
rollover for purposes of the one-year rule because the
transferred funds are not within the direct control and
use of the beneficiary).
37
00188
When receiving a distribution from a qualified plan or an
IRA, the recipient (taxpayer) must determine whether it is best
to receive the distribution and pay the relevant taxes or to
rollover the distribution into another retirement account.
The
need for current income and the rate of return available to the
taxpayer are both relevant factors.
Assume that, in 1984, H is sixty years old and receives
a $300,000 lump sum distribution from his Keogh plan.
Assume the
distribution otherwise qualifies for long-term capital gain treatment and the favorable ten year averaging provisions.
Also,
assume that the distribution qualifies for rollover into an
IRA.
Initially, the amount of tax on this lump sum distribution
should be determined.
Assume that one-half of the distribution
qualifies for long-term capital gain treatment and that H's
incremental tax rate is 50 percent.
Since only 40 percent of the
total long-term capital gain will be taxed, the effective rate
at which it will be taxed will be 20 percent (for a total tax
of $30,000).
The 1984 tax on the total lump sum distribution
under the ten year averaging provisions is $68,950 or an effective
rate of 22.98 percent.
Since the effective rate on the capital
gain portion is 20 percent, H would be better off not using the
ten year averaging provisions for the capital gain portion and,
therefore, should not make the election under section 402 (e) (4) (L)
to treat the capital gain portion as ordinary income for purposes
00189
of the ten year averaging provisions.
The total tax on the
lump sum would be $64,475 (i.e. $30,000 on the long-term capital
gain portion and $ 34,475 on the ordinary income portion).
Now, the question is whether to pay the $64,475 of income
tax and invest the remaining $235,525 or whether to rollover the
122
entire $300,000 into an IRA.
A partial rollover could be
123
made
but the remaining amount
would not qualify as a lump
sum distribution and, accordingly, would be taxed as ordinary
income without the benefit of long-term capital 124
gain treatment
or the favorable ten year averaging provisions.
Assume that H simply plans to live on the income produced
by the investment, and assume that H will be able to earn 12
percent from either an IRA investment or a non-IRA investment.
The IRA investment would produce income of $36,000 per year and
the non-IRA investment would produce income of $28,263 per year.
If H did not anticipate needing more than $36,000 per year before
taxes, the IRA rollover may be wise.
However, since all the income
will be withdrawn each year, the IRA will not defer taxes on the
income and, in this respect, it offers no advantage over the
122. See Colby, Tax Planning for Distributions from Qualified
Plans, 40 Inst, on Fed. Tax'n § 3.01, § 3.05[1], at 3-11
(Supp. 1982) .
123. I.R.C. § 402 (a) (5) (A) .
124. I.R.C. § 402(a) (6) (C) .
00130
39
non-IRA investment. 140
If H needs more income than would be pro-
duced by the IRA, he will have to withdraw principal.
The prin-
cipal withdrawals will also be taxed as ordinary income, while
any principal withdrawals from the non-IRA investment will be
tax-free; thus, in this situation, H will lose the benefit of
long-term capital treatment and the ten year averaging provisions
by rolling over the lump sum distribution into the IRA.
Assume that H anticipated not needing additional income
for five years and, therefore, contemplated investing the distribution and allowing earnings thereon to accumulate.
If H
rolled over the distribution into an IRA earning 12 percent, the
investment would grow to $528,6 00.
Conversely, if H paid the
income tax on the distribution and invested the remainder, the
investment would grow to $345,987 (after tax and assuming a 33
percent tax rate).
In this case, if H did not intend to withdraw
the funds over a short period of time after the 5 year period
12 6
expired, the IRA would probably be the better alternative.
ESTATE TAX CONSIDERATIONS
Under section 2039(c), the value of an annuity receivable
by any beneficiary under a qualified plan (including a Keogh plan)
125. See Colby, supra note 122, at § 3.05[1], 3-12.
126. See id. at § 3.05[1], 3-14.
40
will be excluded from the decedent's gross estate.
The exclusion
does not apply to the extent the amounts payable are attributable
127
to contributions made by the decedent.
This would appear to
rule out any exclusion for the self-employed person's estate
because he made all the contributions on his behalf to his selfemployed plan.
However, section 2039(c) states that, for purposes
of the estate tax exclusion, contributions made on behalf of the
decedent while he was a self-employed individual shall be considered as made by a person other than the decedent.
Lump sum distributions from Keogh plans do not qualify for
estate tax exclusion unless the beneficiary elects to waive the
favorable ten year
12 8 averaging provisions and long-term capital
gain treatment.
If such an election is made, then all amounts
received from the Keogh plan will be excluded from the decedent's
estate (except the portion attributable to the decedent's contributions). However, the exclusion is limited to $100,000.
An IRA may be excluded from the decedent's estate if it is
129
payable in the form of an annuity.
The annuity must be in the
form of a contract or other arrangement providing for a series of
127. I.R.C. § 2039(c). The amount of the annuity for which no
estate tax exclusion is available is equal to that part of
the value of the annuity which bears the same proportion
to the total value of the annuity as the contributions
made by the decedent bear to the total contributions made.
128. I.R.C. § 2039 (f) (2).
129. I.R.C. § 2039(e).
4
00132
substantially equal periodic payments to be made to the beneficiary over a period extending for at least 36 months after the
date of the decedent's death.
The estate tax exclusion applies only with respect to the
131
gross estate of a decedent on whose behalf the IRA was established.
Therefore, the estate tax exclusion will not apply to the estate
of an individual who inherited the IRA.
An interesting question arises relative to community property states.
Does the exclusion apply to the interest of a
taxpayer's spouse in benefits accumulated under the taxpayer's
IRA when the spouse predeceases the taxpayer and such spouse's
interest arose solely by reason of her interest in community
132
income under the community property laws of a state?
A
strict reading of section 2039(d) does not comport with the
conclusion that the exclusion available under that subsection
130. Id. I.R.C. § 2039(e) provides that no estate tax exclusion
is available for the portion of the value of the amount
receivable under the IRA which bears the same ratio to the
total amount receivable as the amount which was contributed
to the IRA and which was not allowable as a deduction under
section 219 bears to the total amount contributed to the
IRA.
131. Treas. Reg. § 20.2039-5(a)(2)(i). See Elinsky, Estate
Planning for Distributions from Qualified Retirement Plans,
39 Inst, on Fed. Tax'n § 55.01, § 55.04[4]# at 55-31 (1982);
Stuchiner, Impact~of the Economic Recovery Tax Act of 1981
on Estate Tax Planning Aspects of Employee Benefits, 16
Inst, on Est. Plan, f 1000.1, 1 1002.3, at 10-10 (1982).
132. See Elinsky, supra note 131, at 55-31 - 55-32.
42
00193
extends to a spouse's community property interest in her husband's
IRA.
Nevertheless, a committee report accompanying the Tax
Reform Act of 1976 stated that "the interest of a taxpayer's
spouse under the community property laws in benefits accumulated
under an individual retirement account or H.R. 10 plan is also
to qualify for the estate tax exclusion when the spouse prede133
ceases the taxpayer."
TEFRA made a very important change to section 2039.
TEFRA
added, to section 2039, subsection (g) which limits the section
2039 exclusion (under either subsection (c) or (e)) to a maximum
of $100,000. 134 Now, a planning device may be to make $100,000
of the plan distribution payable to a non-marital trust and the
remainder payable outright to the decedent's spouse. 135
The
unlimited marital deduction will exempt the portion going outright
4
. the
4.u spouse. 136
to
133. H.R. Rep. No. 1380, 94th Cong., 2d Sess. 69 (1976). Curiously,
this apparent oversight in statutory drafting has not been
corrected.
134. I.R.C. § 2039(g) is effective for decedents dying after
December 31, 1982.
135. Adams & Bieber, Estate Planning Implications of TEFRA, 9
Tr. & Est. Feb. 1983 at 37, 38. See Esterces, When a rollover
or annuity option for plan benefits should be used to defer
tax, 9 Tax'n for Law. 354, 357 (1981).
136. I.R.C. § 2056.
43
00134
If the portion going to the wife otherwise qualifies, then
she would have the benefit of long-term capital gain treatment
137
and she could elect the ten year averaging provisions.
This
portion will, however, generally be included in her estate upon
her death.
The $100,0 00 portion should escape taxation in both
spouses' estates.
If the decedent had made voluntary nondeductible contributions to the plan, his will should designate that the portion of
the value of the assets in the plan attributable to his nondeductible contributions be allocated to his spouse.
The reason is
that under section 2039(c) and (e) nondeductible contributions
by the decedent are not eligible for the estate tax exclusion.
Presumably, if the nondeductible contribution portion of the plan
assets were allocated to the
138decedent's spouse,
for the marital deduction.
it will qualify
137. If she so chose, the wife could elect to forego the longterm capital gain and favorable income tax treatment and could
rollover the distribution into an IRA, thereby deferring
tax on the distribution until she attained age seventy and
one-half. I.R.C. §§ 402(a)(7), 408(a)(6). However, note
that, if the surviving spouse chooses the rollover option,
she may not begin receiving distributions without the
10 percent penalty tax until she attains age fifty-nine
and one-half. I.R.C. § 408(f)(1).
138. See Adams & Bieber, supra note 135, at 38-39. The authors
suggest this type of allocation but caution that the IRS
might claim that a "ratable share of the contributions must
be allocated to the $100,000 portion being received by the
non-marital trust, causing that share of the contributions
to be taxed for estate tax purposes."
44
00135
If the decedent has both a qualified plan and an IRA, the
decedent should make up to $100,000 of the IRA payable to the
non-marital trust and make the qualified plan payable to the
139
spouse.
The reason for this is that distributions from an IRA
do not qualify for long-term capital gain treatment or the favorable
ten year averaging provisions.
If the qualified plan were paid
in a lump sum to a beneficiary other than the surviving spouse,
the estate tax exclusion would be available only if the beneficiary
were to waive long-term capital gain treatment and the favorable
income tax provisions.
However, if the qualified plan were dis-
tributed in a lump sum to the surviving spouse, long-term capital
gain treatment and the favorable income tax provisions need not
be waived since the marital deduction will exempt the portion
received by the spouse from the decedent's estate irrespective of
section 2039.
Planning for retirement benefits must focus on both income
and estate tax considerations.
If the decedent wants to assure
exclusion of a qualified plan from his estate, he can make the
benefits payable in other than a lump sum (i.e. an annuity).
such a case, while long-term capital gain treatment and" the
139. See id. at 39.
45
0013t
In
favorable income tax provisions are unavailable, 140 a $100,000
141
maximum exclusion for the decedent's estate is available.
It should be remembered that for decedents
dying after
December 31, 198 3, the Code places a limit on the time over which
payments can be made following the death of the decedent.
Under
the provisions governing both Keogh plans and IRAs, the entire
interest must be distributed within five years after the dece142
dent's death.
There is an exception
if
prior to his death
the decedent had begun to receive distributions over a term
certain not extending beyond the life expectancy of the decedent
143
or the joint life expectancy of the decedent and his spouse.
In that case, the distribution may continue over the term certain.
Requiring that distributions be completed within five years
may impose rather onerous income tax burdens upon the beneficiaries
of the distributions; therefore, it may be preferable to spread
the distributions over as many beneficiaries as possible to ease
the income tax burden.
Also, some plans permit a beneficiary to
elect whether to receive the benefits in a lump sum or as an
annuity.
This type of provision would facilitate maximum tax
140. Although the distributions are not eligible for the favorable
ten year averaging provisions (because they are in other than
a lump sum), they will be eligible for the regular income
averaging provisions. See I.R.C. §§ 1301 - 1305.
141. I.R.C. § 2039(c), (g).
See Adams & Bieber, supra note 135, at 38.
142. I.R.C. §§ 401(a)(9)(B), 408(a)(7).
143. I.R.C. §§ 401(a)(9)(B), 408 (a)(7)(B).
46
planning by allowing for a decision based upon the actual facts
existing at the decedent's death.
144
Finally, it should be mentioned that death benefits may be
145
eligible for the $5,000 income tax exclusion.
Distributions
will not be eligible for this special income exclusion if the
"employee possessed, immediately before his death, a nonforfeitable
right to receive the amount while living." 14 ^
CONCLUSION
Planning for .retirement benefits must be done on an individual
basis; it requires careful consideration of the individual's
particular circumstances and needs.
The individual's ability
to make investments for retirement or his need for current income,
the rate of return available to the individual, the length of time
over which an investment will be made and allowed to accumulate,
the incremental income tax rate, and the income and estate tax
provisions relative to retirement benefits are all important
factors to be considered when charting a course toward financial
security during retirement.
Individuals who participate in employer plans are still
eligible to set up and make deductible contributions to an IRA.
144. See Esterces, supra note 135, at 357-358.
145. See I.R.C. § 101(b); Treas. Reg. § 1.101-2.
Colby, supra note 122, at § 3.07, 3-20.
146. I.R.C. § 101(b)(2)(B).
mm
See also
As illustrated in this paper, the ability to deduct contributions
and the ability for earnings on such contributions to accumulate
tax free are key ingredients in the attractiveness of an IRA.
Furthermore, it has been illustrated that the penalty tax for
early distributions from an IRA should not be a substantial deterrent to investment in an IRA.
The statutory provisions governing taxation of retirement
benefits are rather cumbersome; however, a knowledge of those
provisions will facilitate proper planning by minimizing tax
burdens and, thereby, maximizing the amount of assets available
during retirement (and passing to beneficiaries upon death).