Tax trap: Pensions, IRAs still face more than 70 percent taxation

February 1, 2008

While nothing has been decided yet, all signs point to the clear fact that significant taxation of assets at death will continue to be an estate planning fact for the foreseeable future.

Key Points

While nothing has been decided yet, all signs point to the clear fact that significant taxation of assets at death will continue to be an estate planning fact for the foreseeable future.

Indeed, for most physicians, the area where such taxes will hurt the most remains pensions and IRAs, where more than 70 percent taxation can still be the norm.

Legislative update

The proposals closest to passing essentially would have raised the estate tax exemption (the amount below which no federal taxes would be due) to $5 million per person, or $10 million per couple - and lowered the tax rate to around 20 percent.

Obviously, we have no crystal ball to tell us whether any reform legislation will ever pass. We do not believe that you should rely on an exemption of more than $1 million per person and a combined federal and state estate and inheritance tax rate of less than 55 percent, since this is how the current law will apply for individuals dying after 2011.

However, for purposes of this article, we'll give all of you eternal optimists the benefit of the doubt, and we'll assume a $3.5 million exemption and a federal estate tax rate of 25 percent are enacted.

While this would be a significant benefit to any two-spouse families with a net worth under $7 million, families over these amounts would still pay a significant tax.

Even more, these rules do not in any way impact state estate or inheritance taxes. Why is this so important?

When the federal government implemented the estate tax "repeal" back in 2001, a relatively unpublicized part of the law change was the cutting of estate tax dollars that went from Internal Revenue Service (IRS) to the states.

Under the pre-2001 law, individual states shared heavily in the estate tax revenue collected by the IRS - thus, they had no need to impose their own estate tax. Because of the "repeal," states stood to lose billions of dollars.

Not surprisingly, what have many states done? You can guess - re-implemented their own state estate tax or inheritance tax.

A state "estate" tax is similar to the federal estate tax in that it is levied on a decedent's estate before it is distributed to heirs.

An "inheritance" tax - like the card you feared picking up when you played Monopoly - is levied on the heirs once they receive their inheritance. Thus far, 24 states, plus the District of Columbia, have already instituted either a state estate tax or state inheritance tax.

While the state estate tax rates may not seem very high -16 percent is the highest - they are meant to be in addition to federal estate tax rates, which still are 46 percent in 2006.

As state deficits continue to increase in most states, we predict that states will continue to raise their rates over the next decade.

As state legislators continue to be pressed to find revenues, many experts predict that more and more states that have yet to implement their own estate and/or inheritance tax will do so; the states that have already enacted such taxes will likely raise their rates.

In summary, if a compromise bill does eventually pass, this is what you can expect in terms of estate taxes:

Of course, even worse than this scenario is the case where no reform is passed in Washington - as our present rules would stay in place. These rules basically keep a $2 million exemption per person and a 46 percent estate tax rate from now until 2010 (2007-2009 rules are slightly better).

In 2010, the estate tax is fully repealed, only to be re-instituted again in 2011 with a $1 million exemption and a 55 percent tax rate.

In other words, if you don't die in 2010, things are much worse under present rules than any likely reform legislation.