Most of the assets are funds in some kind of qualified plan (such as an IRA, 401(k), profit-sharing or the like) or other funds that have been accumulated over the reader’s lifetime. Sometimes the funds are in a trust, partnership or other entity. But the struggle is always the same: how to invest the funds.
Historically low interest rates, the lousy economy, the uncertainty of Wall Street and other negative domestic and international factors have created an investment problem that seems to have no known solution. What can we do?
Enter the tax law, and tax-advantaged investments. For tax purposes there are two types of funds you can invest: qualified and non-qualified funds. Qualified funds such as an IRA are subject to double taxes, both income and estate. Non-qualified funds are only subject to the estate tax.
There are an endless variety of tax-advantaged strategies to accomplish your investment goals. The examples that follow are the two strategies we use most frequently in our tax practice.
Income Booster Strategy (IBS)
Larry, 70, is retired and in a 25 percent income tax bracket, without enough wealth to worry about estate taxes. Joe, on the other hand, is a well-to-do business owner, also 70, and intends to keep working forever, albeit at a slower pace. The example below shows the results for Larry’s $250,000 invested in an income contract, and Joe’s $2.5 million. Before starting the IBS, both were earning only 2 percent on their non-qualified funds. Annual income from the income contract is divided into income tax and a life insurance premium to replace the amount invested, and the balance is spendable income. The numbers speak for themselves: more spendable income and more to family.
Qualified Plan Rescue (RPR)
The cast of characters is identical, but this time the funds are in a qualified plan, a rollover IRA earning 2 percent. In this example, the IRA funds are used to buy the income contract, a tax-free transaction at its inception (again, thank you tax law). However, each annual payment is subject to the full income tax rate, the same as if a distribution had been made by the IRA.
Larry locked in $250,000 for his family via the life insurance, and will enjoy a $10,150 income per year for life (4.06 percent after tax on the $250,000). Joe, because he does not need the income, chose to use all of his “after-tax income” to purchase life insurance for the extraordinary face amount of $4,642,800, completely tax-free. How much would Joe’s family have received if he got hit by the proverbial bus without doing an RPR? Only about $750,000 because of the double tax on qualified plan money. So the RPR strategy turned $750,000 of after-tax money into $4,642,800 tax-free for Joe’s family. As my grandkids say, “Awesome.”
The RPR strategy is flexible and can be designed to accomplish your goals. It’s worth checking out if you have a large amount in a qualified plan.