"... pension assets passing through an estate can face virtually confiscatory marginal tax rates between 92 and 99 percent."
"Pensions are widely thought to be attractive tax shelters which encourage saving for retirement," begins a recent study by NBER Research Associates John Shoven and David Wise. But in The Taxation of Pensions: A Shelter Can Become a Trap (NBER Working Paper No. 5815), they illustrate how "pension distributions can face marginal tax rates as high as 61.5 percent; pension assets passing through an estate can face virtually confiscatory marginal tax rates between 92 and 99 percent." And, the authors caution that the circumstances under which these high marginal rates will be encountered are not limited to the rich, and in fact may face people of moderate incomes who participate in a pension plan over a long career.
Two little known provisions of the Tax Reform Act of 1986 (TRA 86) -- the excess distribution and excess accumulation taxes -- are responsible for this phenomenon. According to these provisions, beginning in 1987 any withdrawals from qualified pension plans exceeding $150 thousand per year face a 15 percent additional income tax. The $150 thousand figure was left unchanged from 1987 to 1995, then raised to $155 thousand for 1996, and now is effectively indexed for inflation. This 15 percent surtax is not deductible against either federal or state income taxes, so it simply adds 15 points to a household's marginal income tax rate on pension withdrawals. Shoven and Wise write that it is often referred to as the "success tax" since it can be triggered by particularly successful investment returns or by career earnings success. (The recent legislation that raised the minimum wage included a provision that temporarily suspends the 15 percent excise tax on "excess distributions" for 1997-9.)
The 15 percent excess accumulation tax in TRA 86 applies to the estates of people who die with pension accumulations deemed excessive. "Excessive accumulation" is defined as having assets that exceed the value of a single life annuity paying out $155,000 per year, for someone with the life expectancy of a person the same age as the deceased. Assets in qualified plans over this amount face the extra 15 percent tax. The actual amount depends on the decedent's age: using the currently allowed life expectancy tables and the permissible 8.2 percent interest rate gives limits of $1.2 million at age 65; $1.16 million at age 70; and roughly $795,000 at age 80. This excess accumulation tax can be deferred if assets are transferred to a surviving spouse.
The estate tax treatment of pension accumulations changed dramatically with the passage of the Tax Equity and Fiscal Responsibility Act of 1982. Before 1983, benefits payable to a beneficiary from qualified accounts (pension plans, IRAs, Keoghs, and the like) were excluded completely from the taxable estate. The 1982 Act limited the exclusion to $100,000. That limited exclusion was repealed with the Deficit Reduction Act of 1984, so that pension wealth has been completely taxable for deaths occurring after 1984.
The reason that even moderate income individuals can become subject to these provisions is that "the wealth accumulated at any particular age depends on five variables," Shoven and Wise write: salary levels, contribution rates, starting age(of pension saving), the rate of salary growth, and the rate of return on investments. Any combination of those variables that leads to accumulation of more than $1.2 million at age 70 will trigger the tax on excess accumulations. For example, the authors explain, someone who works between ages 25 and 70, makes $40,000 at age 50, and consistently contributes 10 percent to a pension plan invested in the S & P 500 will likely be penalized by the success tax.
In this way, the advantage of pensions relative to conventional saving is reduced greatly, and in many cases eliminated. Even in cases where additional pension saving still provides more resources in retirement than conventional saving, when the plan owner dies, the heirs get less than if the saving had been done outside of a pension plan. The availability of tax advantaged investments outside of pension plans also reduces the advantage of pension saving. The excess distribution and accumulation taxes thus create an incentive to withdraw money while living, rather than risk the high rates faced by pension assets transferred through estates.