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Tax-advantaged investment strategies for everyone

Nov. 1, 2010
Three strategies we most often use in our real-life tax practice.

Investors are suffering. Interest rates are at historic lows. The stock market, plagued with roller coaster-like volatility, is like a Las Vegas casino. Many readers of this column complain that it feels like they have been fleeced by Wall Street. Most have either totally or partially (usually a large portion of their portfolio) abandoned the equity market.

Where have these ex-equity players put their money? In low-yield, fixed-rate stuff like CDs, savings accounts and U.S. Treasury bonds.

Even though the readers know I am a tax guy, they seek my investment advice. Sorry, but I just don't have those skills. But according to almost every reader I talk to, neither do their professional advisors have the skill to win in a down market or get them out without suffering a big loss.

What to do?
Would you believe that a hated enemy — the Internal Revenue Code — has the answers? There's an old saying that goes, "You must know your enemy before you can defeat him." We are about to apply some rules found in the enemy's code that will delight those who are conservative investors by nature or who have become conservative because of current conditions.

But first, let me tell you what my survey with clients and column readers who call me has taught me about the typical goals of a conservative investor. The conservative investor wants to increase income, minimize risk, lower taxes and maximize inheritance to their family.

For tax purposes there are two types of funds you can invest: qualified funds in an IRA, profit-sharing, 401(k) or similar plan, or non-qualified funds, usually in your personal bank account or funds you control in a business, trust, partnership or other entity.

There are an endless variety of tax-advantaged strategies to accomplish the four goals listed above. The following are examples of the three strategies we most often use in our real-life tax practice.

Hidden equity strategy
Lenny is the little guy (in a 25% income tax bracket/not enough wealth to worry about estate taxes); Sam is the supervisor (a bit higher income tax bracket/no estate tax problem); and Joe is the business owner (35% income tax bracket/55% estate tax bracket, using 2011 rates). All are 70 years old, retired (except Joe) and in good health.

Hidden Equity Strategy (HES) is a simple two-step strategy: purchase a lifetime income contract that pays a fixed annual amount every year for as long as you live. Divide the annual income into two parts: one part for income, the second part to pay premiums on a life insurance policy to replace the cost of the income contract.

The schedule below is an example that shows the results for Lenny (invested $250,000) and Joe (invested $2.5 million). Both were earning 2% on their funds before starting their HES.

The numbers speak for themselves: more "spendable income" and more to family. Thank you Internal Revenue Code. Please note the numbers for Sam, the supervisor, would be similar.

Qualified plan rescue
For this example the cast of characters are identical and everything is the same except the funds are in a qualified plan (IRA, 401(k) profit-sharing, etc.), in this case a rollover IRA, which was earning 2%.

This time the IRA funds are used to buy the income contract, a tax-free transaction at its inception (again, thank you code). However, each annual income (when received by Lenny and Joe) is subject to the full income tax rate, the same as if a distribution had been made by the qualified plan.

You'll love these results:

Lenny locked in $250,000 (at his death) for his family while he will enjoy a $10,150 income per year for life (4.06% after tax on the $250,000). Joe, on the other hand, does not need the income and chose to use all of his "after-tax income" to purchase life insurance for the extraordinary amount of $4,642,800 … 100% tax-free (from the estate tax).

How much would Joe's family have received if he got hit by the proverbial bus? Only about $750,000 because of the double tax (income and estate) on qualified plan money. So the Qualified Plan Rescue (QPR) strategy turned $750,000 of after-tax money into $4,642,800 (tax-free) for Joe's family. Wow!

Obviously the QPR strategy is very flexible and can be designed to do tax miracles for specific goals. The numbers for the likes of Joe usually look even better when Joe is married and the insurance involved is second-to-die.

Life insurance
Want to increase your income, then legally avoid the income tax on that income, and have your capital (plus all earnings) go to your family tax-free. No, it's not a fantasy. It's Conservative Investors' Life Insurance (CILI). It's perfect for a guy like Joe, who is married to Mary (also age 70).

Joe and Mary buy a $3 million second-to-die CILI policy (it could be any amount) with an annual premium of $70,548. The policy currently earns 3%.

The payoff on their investment comes after the second death and is determined as follows. This example assumes that after 10 years — age 80 — both Joe and Mary get hit by the same bus. Their heirs, kids and grandkids would receive:

  1. Death benefit $3,000,000
  2. Premiums paid ($70,548 times 10 years) 705,480
  3. Interest earned on premiums paid (at 3%, but would be higher, If interest rates rise, or lower, if Interest rates fall) 111,999

Total amount (tax-free) to heirs $3,817,479

Of course, the longer that either Joe or Mary lives, the larger the amount to their heirs.

The easy way to summarize a CILI investment is as follows: You get your investment (premiums paid) back, dollar-for-dollar; plus earnings (3% here) on premiums paid; plus a guaranteed bonus, the death benefit ($3 million); and it's all tax free — no income tax, no estate tax. Neat! The Internal Revenue Code comes through again.

Please note the exact numbers for any specific person in each of the above examples are influenced primarily by age, health and interest rates. Also, the skill of your advisor impacts the final results. So, don't mess with an amateur.

I'm sure you want to know how an HES, QPR or CILI might work for you, your mom and dad, or your grandparents.

So, I have made arrangements for readers of this column to get all the information needed. Just fax your name and birthday (same for your spouse if you're married), address and phone numbers (work, home and cell) to Irv Blackman at 847-674-5299. Mark "CODE article" at the top of the page. Have a question that can't wait? Call Irv at 847-674-5295.

Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847-674-5295, e-mail [email protected], or on the Web at WWW.TAXSECRETSOFTHEWEALTHY.COM.

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