Investors are suffering. Interest rates are at historic lows. The stock market, plagued with roller-coaster volatility, is like a Las Vegas casino. People have either totally or partially abandoned the equity market. These ex-equity players have put their money in low-yield, fixed-rate CDs, savings accounts and U.S. Treasury bonds.
If you’re like these people, you’re looking for investment advice. Sorry, but I just don’t have those skills. I’ve also heard that most professional advisors don’t have the skill to win in a down market or get their customers out without suffering a big loss. So, what should you do?
Would you believe that a hated enemy—the Internal Revenue Code—has the answers? For tax purposes, there are two types of funds in which you can invest: qualified funds (in an IRA, profit-sharing, 401(k) or similar plan) or non-qualified funds (usually in your personal bank account or funds you control in a business, trust, partnership or other entity).
There are an endless variety of tax-advantaged strategies to increase income, minimize risk, lower taxes and maximize inheritance. The following are examples of the three strategies we most often use in our real-life tax practice.
Hidden Equity Strategy (HES)
Lenny is the little guy who is in a 25-percent income tax bracket, which is not enough wealth to worry about estate taxes. Sam is the supervisor. He’s in a bit higher of an income tax bracket, but he has no estate tax problem. Finally, there’s Joe, the business owner. He’s in a 35-percent income tax bracket and a 55-percent estate tax-bracket (using 2011 rates). All are 70 years old, retired (except Joe) and in good health.
A HES is a two-step strategy. First, these men should purchase a lifetime income contract that pays a fixed annual amount for as long as they live. Then, they should divide the annual income into two parts: one for income, and the other for premiums on a life insurance policy to replace the cost of the income contract.
In this example, Lenny invested $250,000 and Joe invested $2.5 million. Both were earning 2 percent on their funds before starting their HES. After starting the HES, Lenny’s spendable income went from $3,750 to $11,400, and Joe’s went from $32,500 to $104,000 after taxes.
| Lenny | Joe |
| Before | After | Before | After |
Annual Income. | | | | |
2% of Investment | $5,000 | | $50,000 | |
Income contract | | $25,400 | | $254,000 |
Less-Income Tax | (1,250) | (5,100)* | (17,500) | (61,000)* |
Less-Premium | _______ | (8,900) | ___________ | (89,000) |
Spendable Income | $3,750 | $11,400 | $32,500 | $104,000 |
% after tax | 1.5% | 4.56% | 1.3% | 4.16% |
| | | | |
Insurance proceeds | $250,000 | $250,000 | $2,500,000 | $2,500,000** |
Estate tax | _____-__ | ___-____ | (1,375,000) | ____-___ |
To Family | $250,000 | $250,000 | $1,125,000 | $2,500,000 |
| |
*Portion excluded from income under Code | **To irrevocable life insurance trust (free of estate tax under Code) |
Qualified Plan Rescue (QPR)
For this example, everything is the same as before, except the funds are in a qualified plan (IRA, 401(k) profit-sharing and similar). In this case, a rollover IRA was used, which was earning 2 percent.
| Lenny | Joe |
Cost of income contract | $250,000 | $2,500,000 |
Annual income | $25,400 | $254,000 |
Less-Income tax | 6,350 | 88,900 |
After-tax Income | $19,050 | 165,100 |
Insurance Premium | | |
$250,000 policy | 8,900 | |
$4,642,000 policy | - | 165,100 |
Spendable Income | $10,150 | - 0 - |
This time, the IRA funds were used to buy the income contract, a tax-free transaction at its inception. However, each annual income (when received by Lenny and Joe) is subject to the full income tax rate, the same as if a distribution had been made by the qualified plan.
Lenny locked in $250,000 (at his death) for his family, and he will enjoy an annual income of $10,150 for life (4.06 percent after tax on the $250,000). Joe does not need the income and chose to use all of his “after-tax income” to purchase life insurance for $4,642,800. This was 100 percent tax-free (from the estate tax).
If Joe got hit by the final bus before setting up the QPR strategy, his family would have received about $750,000 because of the double tax—income and estate—on qualified plan money. So the strategy turned $750,000 of after-tax money into $4,642,800 for Joe’s family.
The QPR strategy is very flexible and can be designed to do tax miracles for your specific goals. The numbers for people like Joe usually look even better when they are married and the insurance involved is second-to-die.
Conservative Investors Life Insurance (CILI)
To increase income, legally avoid the tax on it and have your capital (plus all earnings) go to your family tax-free, use a CILI. It’s perfect for a guy like Joe, who is married to Mary (also age 70). Joe and Mary buy a $3 million second-to-die CILI policy with an annual premium of $70,548. The policy currently earns 3 percent.
The payoff on their investment comes after the second death. (This example assumes that after 10 years, both Joe and Mary get hit by the same bus.) Their heirs (kids and grandkids) would receive $3,817,479.
1. Death benefit $3,000,000
2. Premiums paid
($70,548 times 10 years) 705,480
3. Interest earned on premiums
paid (at 3%, but would be higher,
If interest rates rise, or lower, if
Interest rates fall) 111,999
Total amount (tax-free) to heirs $3,817,479
Of course, the longer that either Joe or Mary lives, the larger the amount to their heirs.
The easy way to summarize a CILI investment is as follows: You get your investment (premiums paid) back, dollar-for-dollar; plus earnings on premiums paid; plus a guaranteed bonus, the death benefit; and it’s all tax free.
