Taxes, Dollars, and Sense
with Retirement Plan and IRA Assets

First, the problem only arises with clients facing significant estate taxes--the 90% tax always begins with a 55% estate tax (applicable to taxable estates above $3 million). Is there anything unique about retirement plan or IRA assets in terms of attracting estate tax? Absolutely not. Every other asset in the client's estate shares as much responsibility for the estate tax as the plan/IRA assets. No one complains about their real estate, securities portfolios, or art collections because of looming estate tax liabilities. So out of that purported 90% tax bill, there's only 35% that could possibly be a legitimate subject for special griping.

That 35% extra tax bite compared to other assets represents the two taxes that the other assets don't face: income tax and the extra 15% estate tax on what the Internal Revenue Code politely terms "excess accumulations". As for the 15% tax, it only applies to retirement plan/IRA assets above a threshold of between $600,000 and $1,400,000 (depending on the client's age and current interest rates at the client's death), or to the assets above the client's remaining "grandfathered amount" if that's larger. Further, the 15% tax is deductible for estate tax purposes, so with a 55% marginal estate tax bracket, the 15% tax costs only 6.75% (15% x 45%), which can be rounded off to 7% to keep the numbers simple.

The other 28% of extra tax (90% - 55% - 7%) represents the anticipated income tax, which has never applied to all the contributions to the retirement plan and IRA, nor to the investment earnings on those contributions. (The net income tax is computed at about 28%, even though the beneficiaries who receive the plan/IRA assets are assumed to be in a 40% or higher tax bracket, because there's an offset for part of the 55% estate tax paid on the assets.)

The big question remains: is it such a bad deal that plan/IRA assets face a 35% extra tax compared to the other assets in the client's estate?
Let's develop a response from the point of view of the client's child. While the client is actively working, let's ask the client's child to choose how the client should accumulate savings to provide for retirement and then to pass on to the child at the client's death. The client can use either a normal personal securities account or a retirement plan account; it's the child's choice.

Everyone has seen these comparisons over the years, and they all reach the same conclusion. The retirement plan murders the personal portfolio as a savings accumulation vehicle for the client's purposes. Depending primarily upon how early the client starts saving and how long he or she waits before beginning withdrawals, the retirement plan will provide net after-tax benefits to the client of between 125% and 190% of the after-tax benefits that can be funded with the personal portfolio. This is obviously a good thing for the child as well as for the client, because a parent who is better provided for in his or her retirement years can better afford to make gifts to the child and the child's own children, and can maintain large insurance policies and do other kinds of estate planning that will brighten the child's financial future.

But what about the child's cut of the remaining plan/IRA assets when the client dies? If the child will keep 45% of any other kind of asset (100% minus the 55% estate tax), but only 10% of plan/IRA assets, then the plan/IRA assets would have to be 4.5 times as great as the personal portfolio assets when the client dies for the child to come out even. ($1,000 of portfolio assets will yield $450 for the child, but it will take $4,500 of plan/IRA assets to yield the same $450.) Now, whatever those retirement plan vs. personal portfolio comparisons may show, they won't claim that the retirement plan will build a pre-tax accumulation equal to 4.5 times the personal portfolio. So, even though the retirement plan is better than a personal portfolio from the client's perspective, it's beginning to seem that the child would come out ahead at the client's death by choosing to have the client save through a personal portfolio.

The best way to appreciate the value of ongoing income tax deferral into the next generation is to ask our hypothetical child what he or she would prefer to receive at the client's death: $1 of regular assets or $1 of plan/IRA assets. Don't leap into the trap of assuming that the $1 of plan/IRA assets is worth much less because every penny will ultimately face income tax. First, not every penny will, because of the offset mentioned above for the estate tax generated by the plan/IRA assets. Second, depending upon (a) the child's marginal income tax bracket, (b) the child's after-tax returns on other investments, and (c) the length of time over which plan/IRA distributions will be stretched, the $1 of an/IRA assets will provide after-tax benefits to the child equal to between $.85 and 1.25 of regular portfolio assets. In other words, the exposure of the plan/IRA assets to income tax will be largely or totally neutralized by the extra value to the child of ongoing income tax deferral.

This means that the client's plan/IRA assets at death don't have to be 4.5 times as large as the personal portfolio accumulation for the child to come out OK. They just have to be enough larger than the personal portfolio assets to cover (1) the 7% net cost of the 15% extra estate tax on some of the plan/IRA assets, and (2) the net disadvantage, if any (which won't exceed 15%), after the negative effect of future income taxes on plan/IRA payouts is balanced against the positive effect of future tax deferral. In other words, even if all of the plan/IRA assets are subject to the 15% extra tax (which is impossible), the plan/IRA assets at worst need to be 127% of the personal portfolio assets to have equal value for the child (127% times 93% times 85% = 100%). If $1,000 of regular assets will yield $450 for the child after a 55% estate tax, the child at most needs $1,270 of plan/IRA assets to yield the same $450 after the 55% estate tax, the 7% net extra tax, and a 15% net disadvantage between future income taxes versus future tax deferral.

Will the plan/IRA pre-tax accumulation at the client's death be at least 27% bigger than the after-tax personal portfolio accumulation? That contest is never even close. The plan/IRA assets will be 1.5 to 2.75 times as large as the personal portfolio, depending once again on the length of the periods over which the savings are accumulated and consumed, and on the client's allocation between stocks and bonds (which determines the long-term rates of return).

(We note in passing the valuable option inherent in the plan/IRA assets: the child has significant control over when those assets become taxable income. At some point during the 15 to 30 years after the client's death, there is a good possibility that income tax rates will dip, or the child will drop into a low bracket or even a tax loss position, so that at least some of the plan/IRA assets can be retrieved at a lower-than-normal rate. No one would bet the farm on it, but it could easily happen.)

The bottom line: with good planning, the plan/IRA assets will provide superior security for the client's retirement years, and a superior inheritance for the child upon the client's death. Instead of a flat 55% estate tax, there will be a 55% estate tax on the plan/IRA assets up to the threshold or grandfather level and a 62% combined estate tax plus extra tax on the plan/IRA assets above that level. (It's critical that the tax on the plan/IRA assets be provided for from other liquid sources, such as a personal portfolio or life insurance, because to the extent the plan/IRA assets were invaded to cover the estate taxes, the income tax deferral opportunity would be lost.) But given that the plan/IRA assets will be much larger at the client's death than a personal portfolio would have been, and given the opportunity to stretch out withdrawals from those plan/IRA assets for a number of years, the child will be very grateful that the client didn't listen to those people who were constantly worrying about some "90% tax."

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This article (which includes the following table) is available exclusively from Brentmark Software. Note: Even with the elimination of the 15% excise tax, most of the issues discussed in this article remain current.

Plan

Portfolio

$25,000
(pre-tax)

$15,000
(after income tax)

average annual return¹

11.0%
(no taxes)

7.8%
(ordinary and CG taxes)

accumulation at age 70

$2,825,113

$1,025,370

annual after-tax payout
[or]
annual after-tax payout²

$209,914 (at 40% tax)
[or]
$174,928 (at 50% tax)

$98,109

balance at client’s death at age 85

$1,480,080

$482,638

present value to beneficiaries
if received over 25 years³

$1,430,941

$482,638

minus estate tax at 55%

($787,018)

($265,451)

minus 4980A tax at 6.75%⁴

($60,254)

n/a

net value to beneficiaries

$583,669

$217,187