Are you lucky enough to be rich (my definition of rich: you are irrevocably in the highest income tax bracket and highest estate tax bracket)? Is one of your significant assets a large amount (about $1 million or more) in a qualified plan: like an IRA, 401(k) plan, profit-sharing plan or similar plan?
Nice! Those big dollar numbers in your plan sure look good. But did you ever do the dreadful tax math? Let’s do it together. To make it easy, suppose you take one dollar out of your plan: the IRS gets 36 cents in income tax … and 64 cents is left. When you go to the big business in the sky, the IRS estate tax monster socks you again. This time for 40 percent (using 2017 rates) of the 64 cents … another 26 cents (rounded) down the tax drain.
Let’s summarize. The double-tax monster gets 62 cents — sorry, your family only gets a paltry 38 cents. Chances are Congress will change the tax rates — raising or lowering the after-tax results. But one thing is certain — the monster will be well fed.
How much will the double-tax cost your family?
Stop and take a moment to guesstimate your tax loss. For example, you have $1 million in your plan: the tax collector gets $620,000, your family $380,000. A true tax tragedy.
Wait, there’s more bad tax stuff. Your state of residence (except for the few tax-free states) gets an additional piece of the tax action. Of course, over time, your plan investments should grow. That growth only adds to your tax pain.
Adding insult to injury
Let’s follow the plan money: first, during your life and again when you get hit by the final bus.
You probably don’t need your plan funds to maintain your lifestyle. But, like it or not, the year after you reach age 70 ½ you must take a “required minimum distribution (RMD), starting
at 3.65 percent of your plan balance the first year. The RMD rises a bit every year, reaching 5.13 percent in year 10, 8.33 percent in year 20, etc.
By now you know the drumbeat; those RMDs will someday be clobbered by estate taxes. But here’s the real villain: it’s called income in respect of a decedent (IRD). What is IRD? It is the amount in your plan on the day you go to heaven. It’s double taxed.
Simply put, RMD (while you are alive) and IRD (when you die) are designed to literally (but legally by the tax law) steal your plan dollars.
Can you beat these two tax bandits? Yes you can! Unfortunately, the how-to-do-it seems like a secret because few professionals know how. The rest of this article shows you the “how-to” road (via an example) to always win the double-tax game. The example is taxpayer Joe and his wife Mary.
Roth IRA to the rescue
A Roth IRA is the victory path for Joe and Mary to destroy the double-tax monster's greed. The best place to start is with a few basic rules concerning a Roth IRA.
- A rollover can be made from a traditional IRA or any other qualified plan, like a 401(k), profit-sharing and pension, to a Roth IRA.
- The full amount rolled over to the Roth IRA is taxed (as ordinary income) at the time of the rollover. Ouch! The rollover can be made at any age.
- Joe passes. Mary does the rollover from Joe’s IRA to a Roth IRA. Mary now owns the Roth IRA and can take income tax-free distributions as she pleases. No RMDs are required.
- When Mary goes to heaven, the Roth IRA is subject only to estate taxes.
5. Mary makes her three children the beneficiaries of her Roth IRA. The kids have two distribution choices: a.) The Roth IRA account must be completely distributed within five years of Mary’s death; or b.) the funds can be paid out annually (as RMD) over the life expectancy of the beneficiaries starting the year after Mary dies. Of course, all distributions are income tax-free.
Please note that making your grandkids beneficiary allows use of the life expectancy choice to extend the distributions over two generations (typically 50 to 70 years or more).
We call this strategy the “Double-Tax Reverse.” Following is how it is done.
- During Joe’s life (Joe can be any age):
- Joe makes Mary the beneficiary of his IRA (all of Joe’s qualified plans would be rolled into this one IRA).
- Joe with the help of his advisors estimates the amount of income tax that will be due when Mary converts to a Roth IRA (say the estimated tax will be $1 million).
- Joe buys a $1 million insurance policy on his life, naming Mary the beneficiary.
- At Joe’s death:
- Mary does a rollover of Joe’s IRA to an IRA spousal rollover, which is a tax-free transaction.
- Mary converts (it can be all or only part of the funds) her spousal IRA to a Roth IRA. Mary is free to name her children, grandchildren or trusts for their benefit as the beneficiaries of the new Roth IRA accounts.
- Mary receives the $1 million insurance proceeds from Joe’s policy tax-free, which she uses to pay the income tax due on the Roth IRA conversion.
Substitute your name, your wife’s name and the estimated amount of your plan funds in the above example. You enjoy three tax victories: 1.) You indeed kill the double-tax monster in effect, no income tax when the Roth IRA conversion is done; 2.) A tax-free piggy bank for your spouse for life; and 3.) Tax-free distributions to your heirs for one (or more) generations. Break out the champagne!
Be smart. Look into a “Double-Tax Reverse.” One thing should be clear — if you have a large amount in your qualified plans, whether married or single, there is an organized way to beat not only the double-tax monster, but legally avoid any tax (no income tax, no estate tax) while building tax-free wealth for your family.
Got a question or want a free analysis of your situation? Call me at 847/674-5295 or send me an email [email protected].
Irv Blackman, CPA and lawyer, is a retired partner of Blackman Kallick 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.