Are you a high-net-worth taxpayer (in the highest income tax and estate tax brackets)? Is one of your significant assets $1 million or more in a qualified plan such as an IRA, 401(k), profit-sharing or similar plan?
Those big numbers in your plan sound good, but have you ever done the dreadful tax math? To make it easy, suppose you take one dollar out of your plan. The IRS gets 35 cents in income tax, and you have 65 cents left. When you go to the big business in the sky, the IRS socks you again for estate taxes, this time for 55 percent of that 65 cents (using 2013 rates) or another 35 cents.
So the double-tax monster gets 70 cents, and your family only gets a paltry 30 cents. Congress may change the tax rates, raising or lowering the results, but one thing is certain: The double-tax monster will be well-fed.
How much will it cost your family?
Take a moment to estimate your tax loss. If you have $1 million in your plan, the tax collector gets $700,000 and your family gets $300,000—a true tax tragedy. In addition, your state of residence (except for the few tax-free states) gets an additional piece of the tax action.
Let’s follow the plan money, first during your life and then after.
You may not need your plan funds to maintain your lifestyle, but, like it or not, after you reach age 70½ you must take a required minimum distribution (RMD), starting at 3.65 percent of your plan balance the first year.
By now you know the drill: Those RMDs will someday be clobbered by estate taxes. But the real villain is income in respect of a decedent (IRD). This is the amount in your plan on the day you die, and it’s double-taxed. Simply put, RMD and IRD are designed to literally but legally steal your plan dollars.
You can beat these two tax bandits, however.
Roth IRA to the Rescue
A Roth IRA is the key for married couple Joe and Mary to destroy the double-tax monster. Here are a couple of basic rules concerning these plans:
1. A rollover can be made from a traditional IRA or another qualified plan, like a 401(k), profit-sharing, pension and the like, to a Roth IRA.
2. The full amount rolled over to the Roth IRA is taxed as ordinary income at the time of the rollover. The rollover can be made at any age without penalty
After Joe dies, Mary rolls over Joe’s IRA to a Roth IRA. Mary is now the owner of the Roth IRA and can take income-tax-free distributions as she pleases. Since no RMDs are required, the funds continue to grow tax-free for as long as Mary lives.
At Mary’s death, the Roth IRA is included in her estate and subject only to estate taxes. Mary makes her children the beneficiaries of her Roth IRA, which must be completely distributed within five years of her death or can be paid out annually as RMD over the lives of the beneficiaries, starting the year after Mary dies. All distributions are income-tax-free.
How to Kill the Double-Tax Monster
We call this strategy the Double-Tax Reverse:
1. During Joe’s life:
a) Joe makes Mary the beneficiary of his IRA. (All of Joe’s qualified plans would be rolled into one IRA.)
b) Joe estimates the amount of income tax that will be due when Mary converts to a Roth IRA. (Let’s say the estimated tax will be $1 million.)
c) Joe buys a $1 million life insurance policy, naming Mary the beneficiary. (Once Joe reaches 70½, the RMDs can be used to pay the premiums.)
2. At Joe’s death:
a) Mary completes a spousal rollover of Joe’s IRA, which is a tax-free transaction.
b) Mary converts all or part of the funds in her spousal IRA to a Roth IRA. Mary names her children, grandchildren or trusts for their benefit as the beneficiaries of the new Roth IRA.
c) Mary receives the $1 million from Joe’s insurance policy tax-free and uses it to pay for the income tax due on the Roth IRA conversion.
Substitute your name, your spouse’s name and the estimated amount of your plan funds in the above example, and you will enjoy three tax victories: 1) no income tax when the Roth IRA conversion is done; 2) a tax-free piggy bank for your spouse for the rest of his or her life; and 3) tax-free distributions to your heirs.
The exact amount this strategy will prevent from being lost to the IRS depends on the rate
of return in your Roth IRA and how long the
account funds have to compound. For example, using the Rule of 72, if your accounts earn
4 percent, the amount in the Roth IRA will
double every 16 years. Instead of losing about
70 percent of your fund to the IRS, your $1 million will grow to $2 million, and every dollar is
Be smart. Look into a Double-Tax Reverse. If you have a large amount in your qualified plans, there is an organized way to legally beat the double-tax monster and build tax-free wealth for your family.