By Darlene Logan, APS Development Director
APS members attending the Society's March meeting were provided an opportunity to attend a newly offered session on retirement account planning which was led by two skilled and experienced pension benefit and estate planning advisors. The information they provided to the attendees was enlightening to say the least. For example, many APS members did not realize that each year they may be able to use a defined benefit pension plan to shelter up to 100% of self- employment earnings including consulting, royalties from writing a book, fees for editing or reviewing, sales from inventions, income from tutoring, honoraria, and other 1099 earned income. And, almost all APS members did not know that there is a total maximum amount you can save without penalty as assets in your retirement account (TIAA, Supplemental TIAA, IRAs and KEOGHs). With the rise in the stock market, many physicists will easily surpass the limits and will be in the penalty region. Distributions have to be carefully planned around estate tax rules which can claim 75-95% of the accumulations.
Qualified Saving Plan
What are the advantages to using a qualified savings plan to shelter earnings? First of all, the contributions to the plan are tax deductible. Second, the investment earnings on your contributions are not currently taxable. Third, the eventual distributions may be taxed at favorable rates. For example, if you were to contribute $10,000 per year to a qualified savings plan earning 8% per year (net of investment expenses) and if your marginal income tax rate is 40%, then the accumulated savings at retirement age would be as follows:
As one can see, substantial financial returns are obtained by investing inside the qualified plan. You can also vary your tax deductible contributions to the plan from year to year. Further, even when you reach retirement age, you will not need to pay tax on the full amount of your accumulated savings in your qualified savings plans as you may "roll" your accumulated savings to an IRA. In effect, your savings continue to earn income on a tax deferred basis. When the distributions are eventually taken from the IRA, they will be treated as ordinary income for income tax purposes.
Dangers of Over Accumulation in Retirement Accounts and Options
In planning for distributions from qualified retirement plans and individual retirement accounts, be aware that these distributions may be subject to a number of adverse tax rules. At death, the benefits in such plans may be subject to the federal estate tax which applies to estates exceeding $600,000. Second, the benefits from the plans will also be subject to income tax when received by the beneficiary. Third, excessively large amounts in qualified plans and IRAs, which the IRS deems as excess accumulations, may also be subject to an additional 15% excise tax. The combination of these taxes can be over 75% of the accumulated savings depending upon the size of the account and your age at death. What to do? Naming a spouse as the heir is a choice that makes tax sense as a special rule permits the surviving spouse to defer tax by rolling over the inherited distribution from the account to an IRA.
But what happens to the estate if a child becomes the beneficiary? Acknowledging that the following example uses the maximum estate tax and income tax rates, it still clearly illustrates the point. Assume that there is $1 million in the retirement account which passes directly to a child. If the owner of the account is in the 55% federal estate tax bracket, the federal estate tax consumes $550,000 of the account, leaving $450,000 to the beneficiary, before income taxes. Assuming that the $450,000 would be subject to a maximum income tax rate of 39.6%, this results in federal income taxes of $178,200. This combination of federal estate and income taxes means that the beneficiary will receive $271,800 of what started out as $1 million. This example does not include state income or state estate taxes. Because of this combination of taxes (which can also include a 15% excise tax on certain larger retirement account balances which can be the case for many APS members), qualified plan and retirement assets are particularly useful as sources for potential charitable giving.
If, in this example, the person had named a charitable organization as the beneficiary of the $1 million retirement account, neither estate taxes nor income taxes would have been incurred, and the cost to the family would have been only slightly over 27% of the value of the account. However, perhaps you want to use the retirement account to provide an income interest for a child over his/her lifetime with the charity then benefiting from the assets. If a charitable remainder trust is named as the beneficiary of the retirement account, a charitable deduction for estate tax purposes can be a benefit so that less federal estate tax is paid. Further the payment of the entire retirement account to the charitable remainder trust will not result in immediate income taxation. The effect is that more funds may be available in the charitable remainder trust to be invested for the benefit of the child during his or her lifetime which could actually provide more income than if a bequest of the retirement account had been made directly to them. In addition, a worthy charity benefits from your generosity.
The bottom line is that, in saving for retirement and receiving retirement plan distributions, it is very important to do very careful planning to assure that intended beneficiaries receive the fruits of our labor...not the IRS. Handouts from the March meeting session and information on the speakers, as well as related articles on this subject, are available to APS members at no charge and may be helpful background if you decide to raise this subject with your own financial advisor.
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