Are you Convinced that qualified retirement plans such as pension plans, profitsharing plans, IRAs and 401(k) plans are great? Good for everyone? If so, you have lots of company. After all, a current deduction for contributions to your plan, plus tax-deferred accumulation of earnings could never be a bad tax move. Right?
The clear answer is it all depends on whether you will need that money someday and, in fact, do use your plan funds down the road for your retirement (a truly great tax deal), or you turn out to be rich. My definition of rich is that you are irrevocably in the highest income tax bracket and highest estate tax bracket.
If you are already rich (or become rich in the future), all your qualified plan money, in the end, will be caught in a big tax trap. You face a tax disaster. Simply put, you have a lousy tax asset.
Why? How can this be? Let's look at $100,000 (substitute your own number) in your profit-sharing plan or other qualified plan. The IRS will get 73% ($73,000), your family only 27% ($27,000). A tax travesty!
Here's how the tax law robs your dollars. As the funds are distributed to you from the plans, each distribution is socked by, say, 40% in income tax (again substitute the total of your own federal, state and local income taxes). Painfully, you watch your $100,000 turn into $ 60,000 after the first $40,000 tax bite.
When you go to heaven, the IRS feasts again on the remaining $60,000; this time it's the 55% estate tax (using the 2011 top rate). Another $33,000 is swallowed by the IRS for estate taxes. So, your family winds up with a paltry 27%. Only $27,000.
So far the tax collectors got $73,000. Your home state of residence could also grab an additional piece of the
It's easy to escape
the Qualified Retirement Plan
death-tax action. Sorry, but that's the tax-you-twice law.
In an evil sort of way, the IRS gives you a second chance to pay the double tax. If you die before distributing all your qualified plan funds, your heirs still get hammered for the same 73% double income tax and estate tax. Stop! Take a moment (or ask your tax professional) to apply these awful same-if-you-are-dead-or-alive rules to your plan numbers.
So, if you're rich (by my definition), or likely to become rich, you are probably wondering if you have a way out of this expensive tax trap. Here's one way: the annuity/insurance strategy.
For example, suppose Joe has $1.75 million in his qualified plans. Joe (60 years old) is married to Mary (also 60). Suppose Joe has the plan trustee buy a joint and survivor annuity (continues to pay as long as either Joe or Mary is alive) that pays $130,000 per year. The annual income tax on the annuity would be $ 52,000 ($130,000 times 40%), leaving Joe and Mary with $ 78,000. They use $25,000 to make an annual gift to an irrevocable life insurance trust that buys a $2 million second-to-die policy (on Joe's life and Mary's life). After both are gone, the ILIT will hold $2 million — free of taxes — for their family. Not only is the $1.75 million
in the qualified plans fully replaced, but the $ 2 million insurance proceeds created an additional $250,000 in tax-free wealth.
Remember, that $1.75 million in the qualified plan was worth only $472,500 (27% of $1.75 million) to Joe/Mary and their heirs. This strategy actually turns $472,500 into $2 million. Plus, Joe and Mary will receive the $130,000 annual annuity payment as long as either one of them is alive. Yes, some of my clients call this strategy "a money-making machine."
The variations on the Joe and Mary scenario described above are endless. Many other strategies fit all types of qualified plans and family situations. The point of this column is that you don't have to stand by helplessly while the IRS robs your family of your qualified plan wealth.
Actually, when you know what to do, it's easy to escape the Qualified Retirement Plan tax trap. But you must be proactive. If you do nothing, the tax law will eat your qualified plan for lunch. Use this column to get started. Don't wait. Time favors the IRS.