Disposition of Qualified Plans: An Opportunity for Heirs and Charity
By Lon P. Dufek and Gene Christian 
Download the Planned Giving Today article
November 1996
Volume VII, Number 11

On occasion, someone will say, “If you put an asset into a charitable trust, because of the increased cash flow, capital gain avoidance and income tax deduction, you will end up better off financially than if you sold the asset and invested the after-tax proceeds.”

Rarely Justifiable
In our experience, that kind of statement is rarely justifiable. Charitable Remainder Trusts (CRTs), by their very name, were not intended to make people better off financially. However, if the prospective donor’s objective is to reposition assets which will increase cash flow (principally because taxation is minimized) in the process, then the charitable trust can certainly be the “ticket.” But, people are rarely better off financially by using a CRT. Notice, we’ve used the word “rarely.”

There is one testamentary charitable planning approach that can allow the donor’s heirs to receive virtually the same amount of money–if not more–from a CRT than they would receive as an outright after estate and various other taxes are paid. It involves the use of a CRT to receive a qualified plan.

Overview of Qualified Plans
Qualified plans can be wonderful wealth-building tools. The government allows people to invest money tax-free in several types of plans, which can then compound tax-free over the years as well. The idea is to encourage people to build large enough reserve accounts which can support them during retirement.

However, the old Midas Muffler commercial, “You can pay me now, or pay me later,” is certainly apropos with regard to qualified plans. Since a person chooses to pay tax up front by investing in a qualified plan, he or his designated heirs will have to pay later, and quite likely in significant ways. In other words, qualified plans were designed as retirement vehicles, not inheritance plans.

Consider this: When a qualified plan terminates (often at the end of the plan participant’s life or that of a spouse), the qualified plan can potentially become subject to four forms of taxation: 1) excise tax at 15 percent if the plan has excess accumulations; 2) estate tax computed at the rate applied to the participant’s estate–maximum is 55 percent; 3) income tax on income in respect of decedent (IRD) in the hands of the heirs calculated at the heirs’ state and federal income tax levels; and 4) the possibility for generation skipping tax if the participant intends to directly include grandchildren as heirs in the estate settlement.
(A fifth tax could also be applicable if the donor’s state of residence at death assesses an inheritance tax). What does all this mean? Qualified plans are often taxed at total combined rates between 70-80 percent if they remain in the estate of the deceased plan participant or spouse.

A Charitable Planning Solution
However, there is an answer to this dilemma which can protect the qualified plan’s value from eroding through taxation. It can work to the benefit of heirs–and charity. Encourage the prospective donor to create a testamentary CRT in his estate plan which will be funded with the qualified plan at death.

In so doing, the qualified plan will still be subject to any applicable excess accumulations tax. However, because of the charitable estate tax deduction, approximately 30 percent of the plan’s value will not be subject to estate tax and IRD is avoided altogether! In other words, most of the plan’s inheritance value can be preserved through the use of a testamentary CRT.

Consider this: If the prospective donor leaves the qualified plan in his estate, designating family members as beneficiaries, the heirs will receive only what’s left after taxation. However, the present value of the income stream they would receive from the CRT during the chosen period can provide an even greater inheritance. The value of this income stream is includable in the not estate and therefore is subject to estate tax. So, estate taxes will have to be paid out of other estate assets.

A Comparative Analysis
In the following example, we’ve assumed that the plan participant dies at age 75 and that his qualified plan assets of $1.5 million are used to establish a 15-year term testamentary CRT with a payout rate of 8 percent. Further, the trust earnings (income and growth) were assumed to be 10 percent and the Applicable Federal Rate was 8.2 percent as of the date of death.

First of all, the tax consequences if he transfers the plan directly to his heirs without the CRT: 

Plan Balance$1,500,000
   Excise Taxes1$ 81,696
   Estate Taxes2$ 780,067
   Income Taxes3$ 241,522
   Total Taxes$1,103,286
Net to Family (26%)$ 396,714

Secondly, the tax consequences if the plan is used to fund a testamentary CRT of $1.5 million: 

Trust Income to Family4$1,066,992
   Excise Taxes1$81,696
   Estate Taxes attributable to CRT5$528,676
   Total Taxes$610,372
Net to Family (31%)$456,620

In addition to the family receiving more on a present value basis, the charity receives almost $2 million from the CRT at the end of the 15-year term. Therefore, not only did the family receive more on a percentage basis, but the charity also benefited greatly from this planning technique.

Caveat: It is assumed that the excise and estate taxes attributable to the CRT are $610,372 and will be paid from other estate assets as the entire $1.5 million will be used to fund the testamentary CRT. 

In the final analysis, this planning technique helps the plan participant control how much and how frequently the value of his qualified plan will be inherited. Consider the alternative: to simply lavish a lump sum all at once on heirs after several levels of tax are paid.
So, the testamentary CRT for qualified plans can be a very appealing tool. While the real value of the inheritance is, in many cases, nearly the same whether or not a CRT is utilized, charity can be included handsomely–in lieu of potentially four layers of taxation. We recognize this can be a difficult subject to fully grasp, but once the prospective donor begins to understand how compelling the numbers can be, we wonder how anyone could say no!

Footnotes to Analysis 

  1. Federal law imposes a 15 percent excise tax on “excess retirement accumulations.” Assuming our prospective donor is a 75-year-old male, he can protect $955,358 from the excise tax (based upon a projected AFR at date of death of 8.2 percent). Therefore, the additional amount of $544,642 is subject to an excise tax of 15 percent, yielding a tax of $81,696. (See update below.) 
  2. Federal estate tax will be due (at the prospective Federal estate tax will be due (at the prospective donor’s highest possible estate tax rate) on the qualified plan’s value minus the excise tax amount (55% x $1,418,304 = $780,067). 
  3. The remaining proceeds of the qualified plan after payment of estate taxes (with the excise tax and state death tax credit added back), estimated to be $779,104 will be IRD in the hands of the heirs and therefore subject to federal and state income taxes. For illustration purposes, we have assumed a combined rate of 31 percent which would yield a tax of $241,522. 
  4. The projected after-tax income to family over the 15-year term from the CRT is $1,431,895. The present value of this income stream discounted at an assumed rate of 4 percent is $1,066,992. This, then, represents the value of the 15-year income stream discounted to the present. 
  5. A 15-year, 8 percent testamentary CRT produces a remainder interest of $457,076, leaving the value of the income stream to the heirs for estate tax purposes of $1,042,924 ($1,500,000 – $457,076). Then, subtracting the excise tax of $81,696 yields $961,228, which is the amount subject to estate tax. Multiplying this amount times the assumed estate tax rate of 55 percent yields $528,676.

Update: President Clinton recently signed into law “The Small Business Job Protection Act” which includes a provision stating that the 15 percent excise tax does not apply to excess distributions received in 1997, 1998 and 1999. In other words, for these three years, plan owners will be able to withdraw any amount from their plans and not be subject to the 15 percent excise tax which was previously assessed on distributions exceeding the $155,000 per year threshold. This “moratorium” is especially valuable for those with large pension who most likely will be subject to the 15 percent tax on excess retirement accumulations at death. Older taxpayers, those in poor health or with short life expectancies should consider accelerating distributions to eliminate the extra 15 percent tax at death. And, of course, let’s not forget those major donors who might consider using these increased distributions for making contributions to capital campaigns and/or funding of planned gifts! 

Lon Dufek is a certified public accountant and certified financial planner who worked for the Baptist Foundation of Arizona in Phoenix for more than 13 years. During his tenure with the foundation, his responsibilities included accounting, taxation, trust administration and planned giving. For the past six-plus years, he has been vice president of Comdel, Inc., the publishers of Crescendo Planned Giving Software. 

Gene Christian is charitable estate and tax advisor for St. Vincent Medical Center in Portland, Oregon. He is an executive member of the Northwest Planned Giving Roundtable and the 1996 program chair for its annual conference.

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