Are qualified retirement plans—pension plans, profit-sharing plans, IRAs, 401(k) plans and so on—beneficial to everyone? After all, a current deduction for your contributions, plus tax-deferred accumulation of earnings could never be a bad tax move. Right? The answer is it all depends on 1) whether you will need that money someday and, in fact, do use your plan funds—down the road—for your retirement (a truly great tax deal); or 2) you turn out to be rich. (My definition of rich is being irrevocably in the highest income tax bracket and highest estate tax bracket.) For the already rich (or those who may become rich in the future), all of your qualified plan money will be caught in a tax trap in the end.
How can this tax travesty occur? Well, let's look at $100,000 (substitute your amount) in your profit-sharing plan or other qualified plan. The IRS will take 73 percent ($73,000), leaving your family 27 percent ($27,000).
Here's how the tax law works: As the funds are distributed to you from the plans, each distribution is socked by, say, 40 percent in income tax (again substitute the sum of your federal, state and local income taxes). Painfully, you watch your $100,000 turn into $60,000 after the first $40,000 tax bite. When you die, the IRS feasts again on the remaining $60,000; this time, it's the 55 percent estate tax (using the 2011 top rate). Another $33,000 is swallowed by the IRS for estate taxes, and your family winds up with a paltry 27 percent ($27,000). So far, the tax collectors made off with $73,000. Your home state of residence could also grab an additional piece of the death-tax action.
In an evil sort of way, the IRS gives you a second chance to pay the double tax. If you die before distributing all of your qualified plan funds, your heirs still get hammered for the same 73 percent double income tax and estate tax. You may want to take a moment (or ask your tax professional) to apply these awful, same-if-you're-dead-or-alive rules to your own plan numbers.
If you're rich (by my definition) or are likely to become rich, you are probably wondering if there is a way out of this expensive tax trap. One possibility is the annuity/insurance strategy. Let's suppose that Joe (age 60), who is married to Mary (also age 60) has $1.75 million in his qualified plans. Let's also suppose that Joe has the plan trustee buy a joint and survivor annuity (which continues to pay as long as either Joe or Mary is alive) that pays $130,000 per year. The annual income tax for the annuity would be $52,000 ($130,000 multiplied by 40 percent), leaving Joe and Mary with $78,000. They use $25,000 to make an annual gift to an irrevocable life insurance trust (ILIT) that buys a $2 million second-to-die policy (on Joe's life and Mary's life). After both Joe and Mary are gone, the ILIT will hold $2 million—free of taxes—for their family. Not only is the $1.75 million in the qualified plans fully replaced, but the $2 million insurance proceeds creates an additional $250,000 in tax-free wealth.
Remember, that $1.75 million in the qualified plan was worth $472,500 (27 percent of $1.75 million) to Joe and Mary and their heirs. This strategy actually turns $472,500 into $2 million. In addition to this, Joe and Mary will receive the $130,000 annual annuity payment as long as either one of them is alive. Some of my clients refer to this strategy as "a money-making machine."
The variations on the Joe and Mary scenario described above are endless. There are many other strategies to fit all types of qualified plans and family situations. The point of this article is that you don't have to stand by helplessly while the IRS robs your family of your qualified plan wealth.
Actually, when you know what to do, it's easy to escape the Qualified Retirement Plan tax trap. However, you must be proactive. If you do nothing, the tax law will eat your qualified plan for lunch. Use this column to get started, and don't wait. Time favors the IRS.