IRS May Take More of Your Retirement Fund

If you’ve been fortunate enough to accumulate lots of money in your pension and other retirement plans, watch out. You may need to act soon to prevent the Internal Revenue Service from slapping an extra tax on a piece of it.

Under a little-publicized provision of the Tax Reform Act of 1986, Congress created a new 15% surtax on what it considers to be excess withdrawals taken from any pension, profit sharing, individual retirement accounts or other retirement plans funded by you or your employer with pretax dollars.

That tax, which takes effect for 1989 returns, would apply to any withdrawal--called distributions in tax jargon--you take over $150,000 a year (beginning in 1992, that threshold amount will be indexed to inflation). It would also apply to any one-time lump-sum withdrawal you take above $750,000.

The surtax applies just to the amounts above those threshold levels. So if you take, say, $200,000 in a year or $1 million in a lump sum, your tax rate on the amounts above the thresholds will rise to 43% from 28%.

Congress’ idea in enacting the surtax was to discourage companies from making excessive or multiple contributions to retirement plans of highly compensated executives.

The tax also, in effect, encourages wealthier individuals to withdraw money from their retirement plans while still alive, rather than passing those funds along to their children. That’s because the surtax still applies even if you pass pension assets to your heirs through your estate.

But the tax will affect more than just fat-cat executives. It could also apply to any normal working stiff who has toiled at a well-paying job for 20 or 30 years or more, regularly contributed to an IRA, Keogh, 401(k) company savings plan or tax-deferred annuity, and enjoyed strong investment performance in those plans. You and thousands of others may be unaware that you have accumulated hundreds of thousands of dollars in your retirement plans.

How can you avoid the surtax?

If you are young and just starting to accumulate retirement assets, sit tight. There is really nothing you can do to exempt yourself, says Tracey Sealer, financial analyst at Bailard, Biehl & Kaiser, a San Mateo financial planning firm.

And the surtax shouldn’t dictate your retirement planning anyway, she advises. You should put as many pretax dollars as you can afford into retirement plans, because the tax-deferred investment buildup over the years will more than pay for any surtax--if it still exists years from now.

But if you are older or have accumulated large assets in your retirement plans already, you may be able to declare most of your funds exempt from the surtax. You can do that if you had at least $562,500 in tax-favored accounts as of Aug. 1, 1986. The exemption, however, is limited to just what you had on that date, not subsequent contributions or investment returns.

To claim this “grandfather” exemption, you must file IRS Form 5329 with your 1988 tax return that will be due April 15. You can’t claim such an exemption after 1988 returns.

To find out if you qualify, ask your retirement plan administrator for how much you had in your accounts on that date. IRS regulations require plan officials to supply that information, even if you no longer work for their company, says Barry Bidjarano, senior manager in the national tax department at the Ernst & Whinney accounting firm.

But the decision to take the exemption is not clear cut, even if you do qualify. Depending on various factors, such as how much you expect to withdraw from the plan and when, you may be better off without the exemption.

For example, if you are not planning to take out more than $150,000 a year anyway, you may actually be worse off taking the exemption, Bidjarano advises. That’s because taking the exemption triggers another set of rules governing withdrawals that could restrict your flexibility. For the same reason, if you expect to take a lump-sum distribution of less than $750,000, there is no need to take the exemption, he says.

Financial analyst Sealer suggests the following rules of thumb:

- If you had less than $750,000 in your retirement plans as of Aug. 1, 1986, generally you should not take the grandfather exemption.

- If you had between $750,000 and $1 million, your decision is not clear cut and you probably should consult a skilled tax adviser.

- If you had more than $1 million, you almost always should take the exemption.

Also, Sealer notes, if you decide to take the exemption, you can always change your mind later and file to have it removed. But a decision not to take the exemption cannot be changed.

Of course, such situations are complex and each individual case is unique. So consider discussing your situation with a qualified accountant or other tax expert. But do so soon--before it’s too late.

Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.