Do you think that qualified retirement plans (pension plans, profitsharing plans, IRAs, 401(K) plans and so on) are the best thing since sliced bread? The clear answer is it all depends on (1) whether you need the money and, in fact, do use your plan funds for your retirement (a great tax deal); or (2) you turn out to be rich (my definition of rich is you are in the highest income tax bracket-—40 percent—and highest estate tax bracket—55 percent). If you are already rich or become rich in the future, all of your qualified plan money, in the end, will be caught in a huge tax trap. You face a tax disaster.
Why? Well, let’s look at $100,000 (substitute your own real number) in your profitsharing plan or other qualified plan: The IRS will get 73 percent, your family only 27 percent.
As the funds are distributed to you from the plans, each distribution is socked by a 40 percent income tax. You watch your $100,000 turn into $60,000 after the first $40,000 tax bite. When you go to heaven, the IRS feasts again on the remaining $60,000; this time it’s the 55 percent estate tax. Another $33,000 is swallowed by the tax collector. So, your family winds up with a paltry 27 percent, only $27,000.
In an evil sort of way, the IRS gives you a second chance. 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.
So, if you’re rich (by my definition), or likely to become rich, you are probably wondering if there is a way out of this painful tax trap. Here’s one way: The annuity/insurance strategy. For example, suppose Joe has $1.75 million in his qualified plans. Joe (60 years old) is married to Jane (also 60). Suppose Joe has the plan trustee buy a joint and survivor annuity (continues to pay as long as either Joe or Jane is alive) that pays $130,000 per year. The income tax would be $52,000 ($130,000 times 40 percent), leaving Joe and Jane with $78,000. They use $25,000 to make an annual gift to an irrevocable life insurance trust (ILIT) that buys a $2 million secondtodie policy (on Joe’s life and Jane’s life). After both are gone, the ILIT will hold $2 million free of taxes for Joe and Jane’s family. Not only was the full $1.75 million in the qualified plans replaced, but an additional $250,000 in taxfree wealth was created.
Remember $1.75 million is only worth $472,500 (27 percent of $1.75 million) to Joe and his heirs. This strategy turns $472,500 into $2 million. Plus, Joe and Jane will receive the $130,000 annual annuity payment as long as either one of them is alive. The variations on the Joe and Jane scenario described above are endless.
Your Family Business Can Dip Into The Big-Company Bag Of Tax Tricks
Family owned businesses are discovering something called nonqualified deferred compensation plans (NDC plans). Such plans offer you great economic and tax advantages or, if done wrong, can be an absolute tax disaster.
Let’s examine a typical (the kind that can be a disaster) NDC plan. Joe Owner will receive a certain sum (say $350,000) at the rate of $50,000 per year for seven years. Often, the amount is contingent, such as 2 1/2 times Joe’s average salary in the last two or three years of employment. The payments usually start after Joe reaches a set retirement age, becomes disabled or dies.
What’s the tax effect of an NDC plan? Nothing, until the payments start. Then, the company gets a deduction as the payments are made and Joe (or his family) pays income tax as payments are received. Its really a good deal if the company is in the same or a higher tax bracket than Joe. If you are likely to be in a low tax bracket after you retire, an NDC plan is for you.
But what if Joe is in a high tax bracket and dies before all of the payments are received? The tax consequences for the company are unchanged. But the payments received by Joe’s family are taxed twice—once for income tax and once for estate tax.
Sound scary? Try this: If Joe’s children are in a 40 percent income tax bracket and Joe is in a 50 percent estate tax bracket, $100,000 turns into $30,000 after taxes—a disaster. Is there any way to beat this horrible tax result?
Yes! Instead of an NDC plan, put your money into a deathbenefitonly plan (DBO plan). The basic difference between the two plans is that a DBO plan starts to pay out only after Joe dies. The tax consequences are the same, except for one wonderful detail: The DBO plan payments are not subject to the estate tax. DBO plans have one more big benefit: The amount of payments due because of the DBO plan reduces the value of your business, further reducing your estate tax.