Beat The “Success” Tax

The new 15 percent excise tax affecting retirement plans calls for difficult decisions now to avoid unnecessary taxes in the future.

March 1 1989 by David L. Buchholz

Swooping down on qualified plan distributions like a diabolical harpy and snatching dollars away from corporate executives is the new 15 percent excise tax, or “success” tax. Simply put, a 15 percent excise tax, in addition to regular income tax, is imposed on aggregate distributions made each year from qualified retirement plans, including Keogh plans, 403(b) annuities, and IRAs (“retirement plans”) which exceed the greater of $117,529, as indexed for inflation after 1988, or $150,000. In the case of a lump-sum distribution eligible for favorable income tax treatment, the limit is the greater of $587,645, indexed after 1988, or $750,000. To make matters worse, this tax may be imposed on a portion of your retirement plan balances at death, even if no distributions have been made during your lifetime.

In order to deal successfully with the excise tax one must understand what can be a potentialy beneficial “grandfather election.” This election is available only to those whose total accrued retirement plan benefits were at least $562,500, as of August 1, 1986. The election would protect-from the excise tax-benefits that had accrued as of August 1, 1986.


There are two methods for determining the amount of annual distributions protected under the grandfather rule: The discretionary method and the attained age method. Furthermore, there are two ways the discretionary method may be applied: the 10 percent method and the 100 percent acceleration method. Protected amounts are reduced each year in which distributions are received.

Eligible CEOs may elect application of the grandfather rule by filing Form 5329 with their federal income tax return for 1988-unless they filed it with their 1987 return. The form must report the initial grandfathered amount, the method to be used to determine the grandfathered portion of subsequent distributions (discretionary or attained age), and other required information. The deadline for filing the election is the due date, including extensions, for the 1988 tax return.


The other manner in which this excise tax may be applied is as an additional estate tax, equalling 15 percent of the amount a decedent’s interest-in all retirement plans at death-exceeds the applicable exemption. The exemption for estate tax purposes is the present value of a hypothetical annuity equalling the greater of $117,529, indexed after 1988, or $150,000 for a period of years equal to the decedent’s life expectancy just prior to his death. However, if the decedent, or the decedent’s executor, elects to apply the grandfather rule, the relevant amounts are the greater of an annuity equalling $117,529 (indexed), or any remaining grandfathered amount (i.e., the present value of an annuity equalling $150,000 is eliminated as an alternative). If benefits are payable to the decedent’s surviving spouse, then the excise tax calculation can be deferred until the spouse receives distributions or dies.


What’s the best course of action? Some situations that are common to many CEOs can provide guidance. For example, one situation involves executives who had total accrued retirement plan benefits of at least $562,500 as of August 1, 1986, but who cannot take distributions currently without paying a penalty (because they’re under age 591/2), or whose retirement plans don’t permit distributions until they retire or otherwise terminate their employment.

The only real decision facing this group is whether to make the grandfather election. Individuals who are unable to reach a decision regarding this election by the regular due date for their 1988 return (April 17, 1989), should delay the decision somewhat by extending their return’s due date.

Most of these individuals who are eligible to make the election will benefit by doing so, even though such an election eliminates their right to apply the $150,000 exemption to future retirement plan distributions. This lost opportunity should not matter much because inflation presumably will drive the $117,529 indexed exemption over the unindexed $150,000 alternative in a relatively short time. Assuming continued indexing, 4 percent annual inflation will cause the exempt amount to be $154,660 in 1995 (six percent inflation means the $150,000 threshold will be crossed in 1993).

Making the election will cost your family tax dollars if, for example, you die before the indexed $117,529 exceeds $150,000; your grandfathered amount is less than an annuity of $150,000 for a period equalling your life expectancy just before you die; and if your surviving spouse is not the beneficiary of your retirement plan balances (or is the beneficiary, but then also dies before the indexed amount exceeds $150,000).

An example helps clarify this conclusion: Assume a 56-year-old executive elected grandfather treatment for his August 1, 1986 retirement plan balance of $1 million, he died late in 1988 when his retirement plan balance had a value of $1.25 million, and the beneficiary of his plan balances was not his spouse.

Because of the election, the amount exempt from the 15 percent excise tax is the greater of the grand-fathered amount ($1 million) or the present value of an annuity of $117,529 for the executive’s life expectancy just prior to his death (which is only $928,550, based on the required use of an IRS table). On the other hand, if no grandfather election had been made, the exempt amount would be the greater of the present value of an annuity of $117,529 or the present value of an annuity of $150,000. Using the same IRS table, this latter present value is $1,185,090. Consequently, making the grandfather election reduced the exempt amount by $185,090, increasing the excise tax by almost $28,000.

If there is no chance an executive who is eligible to make the election, but ineligible to receive benefits now, will incur the excise tax, then he probably should not make the grandfather election. But this situation will be rare for upper-level executives having large retirement plan balances. Even if it is unlikely that an excise tax will be incurred on distributions-which could be the case if an executive’s aggregate account balance is $1.5 million or less at the time distributions begin (see Figure I)-the tax may nonetheless be levied on balances in the retirement plan upon the death of the executive or the subsequent death of the executive’s spouse.

A second situation in which the grandfather election probably should not be made, is when the present value of the $150,000 annuity is expected to produce savings for estate tax purposes (as illustrated in the preceding example). This could be the case if you are in poor health, do not expect to survive until the indexed $117,529 exceeds $150,000, and the beneficiary of your plan balances is not your spouse (or if your spouse is the beneficiary and you do not expect him or her to survive until the indexed amount exceeds $150,000).


Most executives eligible to receive distributions without penalty, but who currently are electing not to do so, should do the same as the first group discussed above (i.e., they should make the grandfather election).

But what about individuals who are currently receiving distributions from retirement plans? The important considerations in making this decision are the size of the potential grandfathered amount, the expected rate of inflation which will drive the $117,529 amount over $150,000, and the projected date of death for the CEO and his spouse. Figure II provides some general guidance in this area.


CEOs who have accumulated sizable retirement account balances may question making additional contributions. This is because the contributions may be subject to income tax at a rate higher than the current 28 percent (or 33 percent) rate when they (and related earnings) are withdrawn in the future, and may be subject to a 15 percent excise tax.

The decision isn’t as difficult as it might first appear. Assume a CEO, age 56, with a current plan balance of $1.7 million (the age and account balance are not important, so long as the CEO clearly will incur an excise tax liability when withdrawals begin), who may make a $30,000 contribution to his plan. The CEO has a choice: he can forgo the contribution, pay income tax on the $30,000, and reinvest the net proceeds; or he can make the tax deduct    ible contribution, let it grow tax-free in the plan for a number of years, and then pay tax on future withdrawals.

If the CEO will begin withdrawals in 15 years, at age 71, and a “first in, first out” analysis is used so that this year’s contribution is considered to remain in the plan for about 30 years, then the tax rate must rise substantially in the interim before the advantage of tax deferred growth is eliminated. If the current tax rate is assumed to be 28 percent, and amounts are assumed to compound at 9.5 percent (pretax) in the plan or 6.5 percent (after tax) outside the plan, then the combined income and excise tax rate must exceed 65 percent (e.g., 50 percent income tax rate and 15 excise tax rate) before the advantage of tax deferral offered by the plan is eliminated. The longer the deferral period, the better the chance to make up (through tax deferred compounding) future costs of excise taxes and increased income taxes.


These conclusions are based on the general notion that taxes should be deferred whenever possible. Thus, tax advantaged plans are assumed to be kept in place or adopted (e.g., a rollover IRA) and excise tax is assumed to be avoided or deferred through use of the 100 percent acceleration option whenever it is possible to do so. Since your situation may require some modification to this general approach, consult a tax professional who understands the complexities of this “success” tax before making any decisions.

David L. Buchholz is Managing Partner of Arthur Andersen & Co.’s tax practice.