CONTACT: Kathleen O'Toole, News Service (415) 725-1939;
COMMENT: John Shoven, Center for Economic Policy Research (415) 725-1569
Thrifty members of the middle class, as well as the wealthy, face major tax trouble with their pensions as a result of changes in the tax laws over recent years, says a new study by economists John Shoven of Stanford and David Wise of Harvard.
When a sizable pension is passed onto heirs, Shoven and Wise show, the tax rates on the last dollars saved can reach levels of between 92 and 99 percent. When the pension money is used by the saver or his or her spouse in retirement, the highest marginal rate for California residents is 61.5 percent, a rate that is 15 percent above the highest marginal state and federal income tax rates.
Most professional financial advisers probably haven't warned their clients who might be affected, Shoven said.
"While people are keenly aware that pensions allow them to save before-tax dollars and compound their investment returns without current taxation, it is our impression that very few people know how pension assets are taxed upon withdrawal or upon the death of the owner of the pension," he and Wise wrote.
People who are old enough to take a pension distribution within the next three years have some good news: Congress has temporarily suspended the excise tax on large pension distributions beginning Jan. 1. The tax will be restored in the year 2000, however, so people who aren't at least 59.5 years old before then do not qualify for the break.
Although a minority of Americans are negatively affected by these taxes perhaps in the range of 1 or 2 percent of the work force, Shoven said, "the households that are affected probably account for a significant portion of total personal savings." Once those households are aware of the tax consequences, they are likely to change their savings habits, he said, and may decide to consume more of their income.
"My personal view is that the country needs to encourage savings, pretty much however it occurs."
Published by Stanford's Center for Economic Policy Research, the study shows that taxes on relatively large pension savings can be much higher than taxes on capital gains, which Congress frequently talks about lowering from the current maximum rate of 28 percent in order to encourage investment, said Henry Aaron, a public finance economist at the Brookings Institution.
Aaron and Charles McLure, a senior fellow at the Hoover Institution who was President Reagan's chief tax policy official, say they agree with the study's authors that high taxes on pensions are poor economic policy. They also think it unlikely that Congress intended the taxes to be as high as they are. The tax committees may have never calculated the cumulative effect of tax changes in recent years on pensions, they say.
"They were probably raised this high inadvertently. It doesn't fit into any defensible tax position that I can think of," McLure said.
"It took me and my co-author considerable time to understand how these tax laws interact, and we were just researching one narrow aspect" of tax law, Shoven said.
Aaron pointed out that the examples used in the study are of people that most people would consider middle class, rather than rich. "I think when members of the ways and means committee realize this, they'll change it. How they'll change it is another question," he said.
Who is affected
Extra taxes on pensions can apply to people who are not wealthy people, Shoven said, if they have been regular pension savers. "Unless you are someone saving 30 or more years with a contribution of 8 to 10 percent of your income, you are probably not affected."
"But someone who is making $40,000 by age 50, which is about the average income for 50-year-olds, could accumulate sufficient pension funds to trigger the extra taxes," he said, if they or their employer consistently contributed about 10 percent of salary to a pension. A pension that totals $1.2 million by the time a person is 70 is large enough to trigger these excise taxes, which means that accumulations in the range of $300,000 to $500,000 by the time a person is 45 or 50 could be enough to trigger the excise taxes later, particularly if the person dies before having a chance to spend much of the pension.
"A major lesson from the study is that retirement and estate planning are two different things," he said. "I think many financial planners now combine those topics and basically advise you to save more in pensions if you have the opportunity."
When people die with substantial unspent savings, their heirs are usually better off, and never worse off, if that savings is held outside of the pension plan at the time of death, Shoven said. That's because the 1986 tax law subjected pension funds to an additional tax that does not apply to other inherited assets.
Pensions refers to all "qualified" retirement savings, including defined-benefit employer-sponsored pension plans, 401(k)s, individual retirement accounts and Keogh accounts. These are vehicles that allow people to shelter some of their current income from current income taxes while saving for their retirement. They have become the predominant way that Americans save.
"Most people believe that these pensions are one of the few remaining great tax shelters left, along with owning a home and municipal bonds," Shoven said. By deferring the income taxes until their retirement, the investor in a pension gets to earn interest on pre-tax dollars. With conventional savings in a bank or corporate bonds, an investor has only the after-tax dollars to invest and must pay taxes each year on earnings.
With a pension, people pay income taxes when they withdraw the money in retirement or their heirs pay income taxes when they inherit it. The income tax rates that apply are those that apply at the time of the withdrawal or inheritance. For their study, Wise and Shoven assumed existing income tax rates would continue.
Many tax changes
To illustrate how greatly the overall taxation of pensions has changed over the last 14 years, however, Shoven and Wise compared the taxes due on the last $100,000 invested in the pensions of three hypothetical 70-year-olds who died with a $1.9 million estate in 1982, 1984 and 1996. All three of the pensioners accrued $1.2 million in today's dollars in their regular pension plan by the time of their deaths. In addition, each had $600,000 in non-pension assets, such as a house, and they had saved $100,000 in a supplemental pension. Their heirs are assumed to live in California so that a specific state's taxes could be calculated as well as federal taxes.
The heirs of the pensioner who died in 1982 would have had to pay income taxes of about $40,000 on the $100,000 supplemental pension if they were in the highest tax bracket of that year about 40 percent. In other words, they paid only regular state and federal income taxes on pensions and no inheritance tax.
The heirs of the person who died in 1984 would have had to pay almost twice as much in taxes, or about $70,000 of the $100,000. That's because in 1983, Congress decided to limit the pension exclusion from estate taxes to only the first $100,000 of pension assets.
In 1984 Congress acted again to eliminate the $100,000 exclusion for anyone who died after that year, and in 1986, it decided to tack an extra 15 percent excise tax onto "excessive" pensions, a tax that other assets didn't face. The result is that the heirs of the third person in the example, who died this year, would pay $85,400 in total taxes out of the $100,000 supplemental pension. "They would get to keep enough to buy an economy car," Shoven said.
In the worst-case example that he calculated, Shoven told a campus audience recently, a New York state heir in that state's highest income tax bracket would pay more than 99 percent in taxes only keeping $270 out of the $100,000 supplemental pension inheritance.
University employees vulnerable
"Stanford people are very vulnerable to these taxes because we tend to have long careers and a very generous pension plan," Shoven said. Stanford employees and the university together routinely contribute 15 percent of the employee's annual salary to a defined contribution retirement plan. The employee can also opt to put more into a supplemental retirement account on the same tax-deferred basis.
For example, in his own situation, Shoven said, "I probably shouldn't be saving more [in a pension] and yet if they change the law, I might have wished I had." Pensions, he noted, are subject to a higher degree of uncertainty than other investments anyway, simply because all the taxes are paid at the end when they are cashed in, and recent history shows that tax laws can change dramatically in a short time.
Aaron said he is one of the pension savers who would be subject to extra taxes on his pension for having saved too much according to law. "I should reveal that in endorsing John's paper, I am acting in my own self-interest," he said.
The excise taxes involved are actually two separate taxes one on so-called "excessive distributions" to savers and their spouses and another on "excessive accumulations" left in the pension when they die.
The excess distribution tax levies a 15 percent tax, in addition to regular income taxes, on any yearly distribution taken by a retiree or spouse that is more than $155,000 in today's dollars. It is indexed to inflation so the amount of distribution that triggers the tax will change with time.
The excess accumulation tax is paid by beneficiaries on inherited pension assets that exceed the value of a single life annuity paying out $155,000 a year, for someone with the life expectancy of the deceased. In other words, the government calculates that a person at age 85 needs less retirement savings than one who is 75, and so lowers the amount of pension exempted from the excise tax as a person ages. The tax is deferred when assets are transferred to a surviving spouse.
Temporary tax suspension, investment strategies
Some people with large pension accumulations will have the opportunity to withdraw all or part of their pension funds in the next three years to avoid the excess distribution tax, Shoven said.
Congress this year tacked on a provision to the minimum-wage bill that provides a three-year window beginning in 1997 in which people who qualify for pension distributions can take pension money out without paying an excess distribution tax. The temporary suspension of the tax was intended to raise the government's income tax collections in the next three years to help balance the short-term federal budget, Shoven said. The tax is scheduled to go back into effect in the year 2000. Heirs of those who die with large pensions in the next three years do not get a similar window on the excess accumulation tax.
People who expect to have relatively high accumulations in the future may wish to rethink their investment strategies, Shoven said. Saving as much as possible through qualified pensions is generally good advice, he said, especially for baby boomers who face the uncertainty of whether their social security benefits will be as good as the benefits of today's retirees.
"But our paper is saying that in some cases, pensions can be beat. It is not always right to save more in a pension plan, particularly if what you are trying to do is provide ultimately for your children or other beneficiaries."
In general, he said, people potentially facing the pension excise taxes might consider first holding inside a pension account those assets that would be taxed most harshly if they were invested outside of the pension plan. This allows them to get the maximum benefit of the pension's tax deferral feature.
"If you want to hold a total portfolio consisting of zero or low dividend growth stocks, high dividend utility stocks and long-term corporate bonds," Shoven said, "it makes sense to place all of the corporate bonds and utility stocks inside the plan before any of the relatively lightly taxed growth stocks are placed inside."
By Kathleen OToole
The pension tax study is available for $5 from the Stanford Center for Economic Policy Research (publication No. 476). To order call (415) 725-6668 or fax (415) 723-8611.