Escaping the Double-Tax Trap

Put retirement funds to use in a rescue plan that minimizes the tax impact and maximizes the payout to your family.

If you have a significant amount of money, say $400,000 or more, in a profit-sharing account, IRA, 401(k) or other qualified plan, you are in a tax trap. To access that money during your lifetime, you will have to pay income taxes. When you die, estate taxes will take also take a bite out of those funds. It is possible, however, to turn that double-tax money into tax-free dollars.

For example, Jack is the owner of a closely held business. He has $1.5 million in an IRA, but his financial advisors estimate his family would receive only about $540,000 of that money upon his death. About 64 percent, or $960,000, would be lost to the IRS in the form of taxes, both income and estate. Jack figured there had to be a way to avoid this huge tax loss.

Jack and his wife Jill are in the highest income tax bracket as well as the highest estate-tax bracket. State and federal taxes take 40 percent of their earnings, and 40 percent of their entire estate will be lost to taxes after their deaths. Of course, Jack and Jill would like to get the full $1.5 million in the IRA to their children after they die rather than yield so much to taxes.

The solution we most often recommend is one we call the “Retirement Plan Rescue” (RPR). It can help almost anyone in high income- and estate-tax brackets, like many business owners, escape the tax trap.

To initiate Jack’s RPR, he first rolled the $600,000 he had in a 401(k) plan into his IRA, boosting the total amount in the IRA to $2.1 million. This alone would do nothing to help lessen the tax impact, however. Taxes would still reap a whopping 64 cents on every dollar, or about $1.34 million. The next two steps in the RPR are what fixed that problem.

Step 1. Jack and Jill purchased a $4.2 million second-to-die life insurance policy through an irrevocable life insurance trust. Setting up a trust to purchase the policy rather than purchasing it themselves enables their children to get every dollar of the insurance benefit, because the trust is not considered part of Jack and Jill’s estate and therefore will not be subject to estate taxes upon their deaths. This guarantees that the family will receive the entire $4.2 million payout from the insurance policy. The original $2.1 million IRA would have had to have grown to about $11.7 million in order to net the family the same $4.2 million payout. The double-tax bite would have been an unbelievable $7.5 million.

To pay the insurance policy’s premiums, Jack uses funds from the $2.1 million IRA. He withdraws $107,030 from the account each year, pays $42,812 in income taxes on that withdrawal, then uses the remaining money to pay the $64,218 annual premium.

But Jack and Jill are only 63 years old. They are in good health and could expect to live another 20 years or more. This begs the question: “How can Jack be sure there will be enough money in the IRA to pay the insurance premium each year?”

Step 2, that’s how.

Step 2. Jack has his financial planners invest the $2.1 million in IRA funds in a diversified basket of annuities, bonds and preferred stocks that net him income of 4.25 percent per year. Together with the IRA principal, that’s plenty of income to pay the annual life insurance premiums well beyond both his and Jill’s life expectancies. He actually could have purchased $6 million or more of insurance, but conservative Jack was concerned about maturing some of his investments and the decline of future income rates of return.

(As a practical matter, death benefits can always be adjusted down in order to lower the annual premiums accordingly yet keep the policy in force.)

We have used the RPR strategy with clients as young as 44 to as old as 82, some purchasing single-life insurance policies and others second-to-die policies like Jack and Jill’s. As long as you are in good enough health to be eligible to acquire life insurance, you will be able to turn the potential double tax into a tax-free (money-making) victory.

Finally, it should be pointed out that an RPR is very flexible. About 30 percent of the clients we’ve worked with who have implemented this strategy only use a portion of their IRA funds to increase how much money their heirs will inherit at the expense of the IRS. They intend to use  the balance for their own retirements—a terrific tax plan. Even more interesting, about 20 percent of the folks who have used the strategy use other funds to pay the tax on their IRA distributions and maximize the wealth their family will receive (via more insurance).