As the oldest boomers, those now 59 1/2 , can begin to live off assets held in employer-sponsored qualified retirement plans, many are inquiring with increasing urgency about potential tax liabilities. On this question, much will depend on the choices they make respecting distributions.
The impact of plan elections on clients’ retirement and estate planning objectives was the theme of a June 22 audio/Web conference sponsored by the Society of Financial Service Professionals, Bryn Mawr, Pa. Titled “Keeping the Tax Sizzle in Estate Planning Strategies,” the session was presented by Eva Ribarits, a principal at Creative Transitions, Wellesley, Mass.
“In the past, I referred to retirement plan assets as tax time bombs,” said Ribarits. “With annual increases in the estate tax exclusion amounts and the repeal of estate tax in 2010, I started calling these assets tax fuses. My hope is that in doing planning with clients, advisors will be able to maintain the sizzle of these tax fuses into the next generation.”
To that end, Ribarits said advisors need to explore with boomer clients three challenges: (1) how to maximize retirement plan assets by minimizing income tax liability; (2) how to transfer assets cost-efficiently (i.e., without probate expenses and with minimal estate tax liability); and (3) how to preserve plan assets for the next generation by understanding the distribution options available to beneficiaries.
As to the first question, participants in employer-sponsored qualified retirement plans need to weigh two choices in determining how best to stretch out payments on any income tax liability. One is to elect (assuming a married couple) a joint and survivor life expectancy annuity, under which the IRS assumes a 10-year age difference between the participant and the beneficiary. If the age difference is greater than 10 years, the tax-trigger will hinge on the difference in life expectancy.
A second method, dubbed net unrealized appreciation or NUA, lets plan participants convert ordinary income tax on distributions to a lower capital gains tax. To qualify for this election the plan must, in addition to being employer-sponsored, include the employer’s securities. And the participant must be able to roll the plan into an IRA.
Ribarits noted, however, that only gains enjoyed on the employer’s securities are eligible for the conversion–and before the IRA rollover. Non-employer securities that clients transfer to the IRA remain subject to ordinary income tax.
Also to consider in weighing income and estate tax implications are the parties named as beneficiaries. Regardless of the party selected–spouse, non-spouse, charity or trust–boomers participating in qualified plans still can leverage the joint and survivor distribution option. But the selection does impact distribution options available to the beneficiary.
Ribarits observed, for example, that many retirement plan documents only will allow the non-spouse to take a lump sum distribution in cash (triggering an immediate income tax) or to take a payout over 5 years.
“One of our three objectives–ensuring that beneficiaries have the flexibility to take distributions over their life expectancies–won’t be satisfied if a non-spouse is named in the employer-sponsored plan,” said Ribarits. “This isn’t an issue, however, with respect to IRAs.”
Ribarits added that while beneficiaries are responsible for income tax liabilities, the plan participant’s estate pays the estate tax. If the tax is attributable to the plan’s income portion, the beneficiary may count the liability as an income tax deduction.
The naming of the plan’s beneficiary has tax implications as well for a popular estate planning strategy: gifting. If the client were to gift an employer-sponsored retirement plan to a spouse, the client would have to take a distribution on the plan assets and pay income tax before the transfer.
The forced distribution is thus at odds with one of the three objectives: deferring income tax payment. The “good news,” said Ribarits, is that no gift tax need be paid if the participant taps the unlimited marital deduction available to couples. When gifting to a non-spouse, she added, both income and gift taxes would be due.
Income tax would have to be paid–though gift taxes avoided–when gifting to a revocable trust or a charity. With regard to the latter, plan participants enjoy one other offsetting advantage: the availability of a charitable income tax deduction.
One of the challenges boomer clients face is how to maximize retirement plan assets by minimizing income tax liability