Three cheers! Now you can, under new rules, use your IRA and other retirement plans to make your children and grandchildren very rich.
Later, I will explain more about how to do it. But first the IRS deserves a standing ovation for creating a tax-saving and wealth-creation show that continues past your life and into the lives of your children and grandchildren. So, relax and enjoy the show. It's long, all thumbs up and very enriching.
Before the show begins, let's take a look at the long-standing rules of qualified retirement plans, which include 401(k) plans, profit sharing plans, IRAs and the like.
The three basic sets of rules are:
In. All is milk and honey, and every penny is deductible. Let's assume a 40% income tax bracket (state and federal combined). For every $1,000 you put in, the out-of-pocket cost to you is only $600. In effect, the IRS put in the other $400. That's a good start.
While in. There's more good stuff. All taxes are deferred until the day funds are distributed to you. Using an 8% return, each $1,000 will compound into $8,000 in 27 years. Stop and take a few minutes to do the math for your particular plan, based on your rate of return and your age.
Out. Now life gets complicated, and worst of all, becomes hurtful to your tax pocketbook. The general rule is that you pay income tax on every dollar you take out at 40% ($400 for every $1,000). Add a 10% penalty if you are not 59½ years old.
Once you reach age 70½, you must take out a certain percentage each year, based on the value of the assets in your plan(s). The percentage (according to an IRS life expectancy table) rises every year, starting with 3.65% at age 70. Here are a few more percentages to show you how these required distributions work: age 79 is 5.13%, age 88 is 7.87% and age 95 is 11.68%. Hey, if you live to age 101, the rate is 16.95%. (A side note: As long as your plan earns more than the required distribution, the funds in your plan will continue to grow. Look for the “how-to-earn-more” hint after the show.)
We are almost ready for show time. First, I have a question. What happens when you die? In general, your plan funds are socked with a double tax: the 40% income tax, plus 55% (using 2011 rates) for that robber estate tax. The result is 27% to your family and 73% to the tax collectors. Put another way, that's $730,000 per $1 million lost in taxes. Ouch!
It's show time. We only need four characters in our little play: 1) Joe, age 70½ with $1 million in a 401(k); 2) his wife Mary, age 62; 3) his son Sam, age 38; and 4) his granddaughter Sue, age 9. Remember, the entire purpose of the play is to show you how to grow Joe's wealth inside his plan by deferring taxes as long as possible. The name of the play is “Stretch Your IRA.”
Sorry, Joe, but you die as the curtain goes up, and there's not much action. It takes 72 minutes to read the basic rules for required distributions after Joe dies, which are a complicated mess. Finally there's some action: Mary explains (in a cute little skit) how a “spousal IRA” allows the distributions to be paid out over her longer life expectancy (Joe's 401(k) was transferred to a rollover IRA shortly after he died). Mary is the beneficiary of Joe's IRA.
A non-spouse beneficiary
Next, it's Sam's turn. In another skit, he explains that because he is the beneficiary of Joe's IRA, the new tax rules allow the IRA distributions to be made over his even longer life expectancy (remember Sam is only 38), instead of Joe's (or Mary's) life expectancy. The title of this skit is, “How to Transfer Qualified Plan Funds to a Non-Spouse Beneficiary's Rollover IRA.” Simply put, the wonderful old spousal IRA rules, under the new law, now apply to all beneficiaries, including kids and grandkids.
Sue's skit brings down the house. The stage is flooded with dollar and hundred dollar bills (not real ones). Imagine distributions based on a 9-year-old's life expectancy. Joe's $1 million would double many times over the years.
The new law allows you to do wonderful things with your plan funds in an original IRA or rollover IRA (a simple transfer to the rollover IRA from any other type of qualified plan). Unfortunately, horrendous complexity makes a professional with expertise in this area essential when implementing the new rules.
Here are two more little tricks that make the proper utilization of the new “Stretch IRA” law even better:
The IRA Inheritance Trust (IRA Trust): This trick has all the benefits of a living trust for non-spouse beneficiaries (such as lawsuit and divorce protection) without sacrificing income tax deferrals. The IRS looks through the trust, which has no life expectancy and simply uses the life expectancy of the trust beneficiaries. Now you can have both protection (of the IRA assets) and tax deferral (Joe's $1 million can grow to $3 million, $4 million or more, depending on the age of the beneficiary and the rate of earnings.)
Life Settlements (LS): The trick is to invest your plan funds — at any age — with a high rate of return and without market risk to accelerate their compounding growth. LS are such an investment. A public company that sells on the NASDAQ sponsors a program for little-guy LS investors. (Typically, LS only belong to large institutional investors with deep pockets. For example, companies like AIG and Warren Buffett's Berkshire Hathaway, which recently started a wholly owned subsidiary with $400 million in funding to buy LS.) For the 16 years the NASDAQ company has been in business, the average annual return on LS has been 15.83%. Because LS are not subject to market risk, rising or falling interest rates or other external forces, LS are the new darling of conservative investors.
The IRA Trust (an outgrowth of the new Stretch IRA rules) and LS give you a new and unique one-two planning punch. If you have a total of $200,000 or more in all of your plans (IRA or others), you owe it to yourself and your family to explore the possibilities of these wealth-building strategies. One or both of these strategies can be used to significantly improve the tax-saving and wealth-building strategies in your existing estate plan. Or, more likely, they can be the centerfold of a new overall lifetime and estate plan combined.
Irving Blackman is a retired founding partner in Blackman Kallick Bartelstein, 10 S. Riverside Pl., Suite 900, Chicago, Ill. 60606; tel. 312/207-1040, or via email at [email protected].