FEDERAL ESTATE TAX TREATMENT OF QUALIFIED PLAN BENEFITS

The federal estate tax is a tax separate from the income tax that is imposed on the value of a decedent's property at the time of death. The estate tax is payable out of the decedent's estate and, therefore, reduces the amount available to the beneficiaries. Only a small percentage of decedents—less than 5 percent—have enough wealth to be concerned about the estate tax because of a high initial minimum tax credit applicable to the estate tax. No estate tax return need be filed for a decedent whose gross estate is less than $675,000 (in 2000). This amount is scheduled to rise incrementally to $1,000,000 in 2006. Also, there is an unlimited marital deduction for federal estate tax purposes—that is, there is no federal estate tax imposed on property transferred at death to a spouse, regardless of the amount.

As a general rule, a lump-sum death benefit, or the present value of an annuity payable to a beneficiary from a qualified plan, is includable in the estate of a deceased participant for federal estate tax purposes. For some high-income participants, avoiding federal estate taxes on the plan benefit will be important. Their estates may be large enough to attract imposition of some federal estate tax. The marital deduction may not be significant, because they may not wish to pay the plan benefit to a spouse—they may be widowed or divorced or may wish to provide for another beneficiary. Also, even if the benefit is payable to a spouse, a spouse is often about the same age as the decedent, and thus within relatively few years most of the property transferred to the spouse is potentially subject to federal estate tax again at the spouse's death. As a result, it is often useful to design a qualified plan death benefit that can be excluded from the participant's estate.

The general rule of the federal estate tax is that all items of property are includable unless a specific code provision excludes them. Thus, qualified plan death benefits are generally includable because there is no specific exclusion. However, the estate tax law does have a specific provision dealing with life insurance, Section 2042. Under Section 2042, life insurance proceeds are includable in a decedent's estate if the decedent has "incidents of ownership" in the insurance policies. Incidents of ownership are various rights under the policy, particularly the right to designate the beneficiary. If a qualified plan death benefit is provided through a life insurance policy, in most places this provision would require inclusion because the participant retains the right to name the beneficiary. Noninsured death benefits presumably would not be excludable in any event.