Gift and estate tax implications for retirement and pension planning

¶ … gift tax issues have been increasingly brought to the forefront. Part of the reason for this, is because these kinds of taxes are often considered to be unfair, by directly taxing the assets that someone has built up of the course of time. A good example of this can be seen with the contentious atmosphere surrounding the extension of the estate tax in 2010. Where, Congress was divided as to if: they should extend the various exemptions or allow them to expire. (Jacobs, 2010) This is problematic, because it means that many individuals have trouble determining how they can plan for the future. In the case of pension funds and retirement plans, this can be particularly challenging. As the money that is accumulated is required to remain in the account, until the individual begins to receive the various funds when they are retired. At which point, any kind of earnings would be taxed as ordinary income during the year that was received. This is troubling, because this kind of policy is discouraging people from investing for their retirement. As they do not have access to: the money when they need it and they will inevitably have to pay taxes on the money when their earnings power has declined (during retirement). As a result, various changes have been proposed to address these challenges facing a host of individuals. To fully understand the situation requires: examining various issues surrounding pension and retirement plans. This will be accomplished through: looking at the current regulations, how this is having an impact upon retirement planning and examining various ways that the different tax regulations can be reformed. Together, these different elements will provide the greatest insights, as to the overall scope of the problems surrounding the taxation of retirement plans.

The Current Regulations

At the heart of all regulation surrounding any kind of pension plan is the Employee Retirement Income Security Act of 1974 (ERISA). This regulates how pension / retirement funds are created and administered. As the law is defining a number of different elements that must be included as a part of any plan such as: setting minimum deposit standards, allowing employees the opportunity to become a participant in the plan and letting the spouse of an employee have a right to a percentage of the plan (with the death of the participant). These different elements are important, because they would establish basic guidelines that all pension and retirement plans would embrace in the future. ("Frequently Asked Questions about Pension Plans," 2011)

As a result, a variety of pension and retirement plans would emerge, to offer employees a number of choices. The most notable include: defined benefit / contribution plans, simple employee pension plans (SEPs), 401Ks, profit sharing and employee stock ownership plans (ESOP). A defined benefit / contribution plan is when they are providing employees with specific benefits that they will receive in retirement. This can be in the form of: a stated amount of monthly income or based upon a predetermined formula. Simple employee pension plans are when employers will make contributions to individual retirement accounts that are held in their names. In general, these kinds of plans will often focus on investing in conservative tax free investments that can grow over a period of time. 401Ks are when the employee can contribute a certain percentage of their income into a company retirement plan. Their employer has the option of matching these contributions and establishing an investment policy strategy. A profit sharing plan is when an employer is sharing the profits that they are making with employees, by distributing a certain percentage of the profits every year into a retirement plan. Employee stock ownership plans are where the employer will make employee contributions through: the purchase of company stock. These different elements are important, because they are showing how the ERISA regulations, would create a number of programs that employees and employers could utilize to prepare for retirement. ("Frequently Asked Questions about Pension Plans," 2011)

Annuities

Annuities are a special situation when it comes to retirement plans. This is a product that is sold by insurance companies, to provide investors with periodic payments that they will receive in different intervals. The idea is to provide: retired individuals and those who are in need of certain amount of money, with the funds they require at a time when the will use it. ("Annuity," 2011) as far as tax liabilities are concerned, the individual will have to pay them in the year that the income was received. This is regardless if the annuity is held in: qualified or non-qualified plans. This is problematic, because it means that many investors (who are using this tool), will have greater tax liabilities down the road. While not being able to protect, the gains or income that was received with the annuity. (Gambone, 2010)

When you step back and analyze the various regulations surrounding pensions and retirement plans, it is clear that they are providing everyone with a basic guideline as to how taxes are accounted for. Yet, beneath the surface various disparities are increasing the overall liabilities that an individual will have. An annuity is a good example of this can be applied to any one of these plans, with most people assuming that it would fall under the same category of qualified / unqualified plans. However, the reality is that the full amount of taxes must be reported as ordinary income on the year that the distribution was received (regardless if it is in qualified or non-qualified plan). This is problematic, because it means that many investors will often purchase these products with the assumption that they will receive the same kind of tax treatment. Then, when they are taking the distributions, is when they find out that these regulations apply to them, resulting in a higher tax liability that an individual will have to pay. (Gambone, 2010)

How this is having an Impact upon Retirement Planning?

The conflicting tax regulations are having an impact upon the way retirement planning is taking place. Where, many individual are investing in annuities with the assumption that their tax rates will be lower when they are retired. However, there are a number of other expenses that are often included with the annuity on annual basis to such as: mortality and expense charges. This is problematic, because these kinds of expenses can eat away at the overall return that is being seen by investors. Once they begin to receive the various distributions, is when the taxes will hurt their overall return, by forcing individuals to pay more (when they could be most vulnerable). This is problematic, because this has often been embraced as retirement vehicle that a host of pension funds as well as retirement plans are using to: increase their return and provide guarantees. The fact that the tax liability does not distinguish between qualified and non-qualified assets, means that they many people will have higher taxes when they begin taking these distributions. (Gambone, 2010) (Fisher, 2010)

This is particularly troubling because this kind of asset is often exempt from various estate and inheritance taxes. As many of the different pension and retirement plans will often claim how these investments are considered to be tax free. Yet, on the federal level there is no such distinction. This is troubling, because the conflicting regulations as far as taxes are concerned, will have an impact upon the underlying return that are investors are receiving. Where, they assume that they will be able to receive a substantial amount of tax benefits, while being able to invest in conservative areas that can provide them with continuous growth. As a result, most people are surprised by the sudden tax liabilities they will have when they begin to receive these different distributions. ("Pennsylvania Inheritance Tax," 2010) ("Pennsylvania Inheritance Tax," 2009)

At the same time, the marginal rate that an individual is paying will determine the overall amount of contributions that they are making to their pension plan. This is because most people will often compare the underlying asset class, with other investments that are outside of different retirement vehicles. The reduction in dividend income and the way that capital gains are being reported, will have an impact upon the kind of financial decisions that investors are making. Where, they will compare the overall tax benefits and availability that they will have to these funds. Given the fact that dividends and capital gains are taxed at a favorable rate on ordinary investment accounts, means that any kind of benefits that are being offered are reduced. This is because most people, will look at the two choices and determine that investing the money outside of retirement vehicles will provide them with: a better return and more flexibility. At which point, they will ignore various retirement accounts and pension plans. This is troubling, because it is showing how the current tax structure is contributing to the underlying problems that are facing individuals (who are investing in retirement assets). As they are receiving: an unfavorable return and the number of options that they have available to them are limited. This is when they will look at other kinds of accounts to invest the funds that are normally earmarked for retirement. Over the course of time, this will mean that the general public will not be focused on investing in these different kinds of assets. (Burtless, 2010)

When you step back and analyze the various issues that are affecting pension and retirement plans, it is clear that they are being impacted by uneven tax regulations. Where, investors are unable to receive the kind of return that they are looking for because: the assets are less liquid and they have higher tax liabilities. This is problematic, because most investors will often compare the underlying assets with others areas. As a result, the favorable treatment of assets that are outside of retirement will receive more focus. This is because, the overall returns are greater and investors have more flexibility among asset classes / access to the money. At the same time, the inability to receive favorable treatment for investments in annuities will cause individuals, to have higher taxes when they begin receiving their distributions. This is troubling, because it means that the overall return will be less and most people will have higher tax liabilities at time when they need the money. As a result, the various disparities in the tax regulations will mean that investors will seek out those areas outside of: various retirement and pension plans. (Burtless, 2010)

How various Tax Regulations can be Reformed?

The different tax regulations, surrounding pension and retirement plans needs to be reformed. This is because of the changes in other aspects of the law have made these areas less attractive. As a result, the policy needs to be adjusted by reducing the marginal tax rates to a point, that they will encourage investors to begin saving for retirement. This means that some kind of approach must be taken that will tax these assets at lower rate in the future. For example, one possible change that could be implemented is that the individual will have a choice, as to what rate they could pay on these assets to include: being taxed at their former or current tax rate. This is important, because it is giving investors a way of increasing their overall returns, when they begin taking distributions by: ensuring that they are taxed at the lowest bracket possible. Over the course of time, this could help to increase retirement savings, by allowing everyone to see how they can improve their return in the future. At which point, many of the different retirement vehicles would become popular. This is because of the changes in the underlying rates of: dividends and capital gains will more than likely increase in the future. At the same time, making annuity distributions more transparent will have an impact on retirement investing. The reason why is because, the current tax structure is causing these assets to be subject to higher rates. This is despite the fact that they are often placed in many different retirement accounts. Therefore, lowering this rate and providing investors with a choice about what bracket should be applied (through either: their former or current rate) will help them to see how this could increase their overall return. When you put these different elements together, this is showing how reducing the overall tax rate for retirement accounts will increase their popularity. At which point, investors can be able to see how this will improve their overall return.

Clearly, the biggest problems affecting various retirement plans are that the underlying assets are being taxed at a higher marginal rate (in comparison with other areas of investing). This is problematic, because it means that many investors will often compare the total return that they are receiving with various retirement plans. Once this takes place, it will inevitably cause a shift in the flow of funds away from these assets. To restore some kind of balance requires that various reforms are initiated. One way that this can be accomplished is through: lowering the marginal rates in these areas, by giving investors a choice between how they will be calculated. This will help them to see how they can receive a better long-term return, in comparison with other asset classes. At which point, there will be a renewal of interest in investing in various pension and retirement plans. This is important, because it is showing how this kind of adjustment, could help to improve the way these accounts are used in retirement planning by: giving investors greater amounts of flexibility. Over the course of time, this will make this particular asset class more advantageous for everyone.