Blackman on Taxes
Do You Have a Small Fortune in an IRA? Learn How to Escape the Double-Tax Monster
Are you a high-net-worth taxpayer—irrevocably in the highest income- and estate-tax brackets? Is a significant asset, worth $1 million or more, a qualified plan like an IRA, 401(k) plan, profit-sharing plan or similar? If so, the tax math can be scary. Assume that for every dollar taken out of the plan the IRS gets 35 cents in income tax. When you die, the IRS socks you again, for 55 percent (using 2013 rates) of the 65 cents for estate taxes—another 35 cents down the tax drain.
I call this the double-tax monster, which in this case leaves your family a paltry 30 cents on the dollar. Chances are Congress will change the tax rates over time, but the double-tax monster will never go away.
How much will the double-tax cost? For a plan worth $1 million, the tax collector gets $700,000, your family $300,000.
Wait, there’s more bad news. Your state of residence (except for the few tax-free states) also receives a cut of the tax action. And, over time your plan investments should grow; that growth only adds to your tax pain and adds insult to injury.
Let’s follow the plan money, during your life and when you die.
Chances are you don’t need your plan funds to maintain your lifestyle. But like it or not, the year after you reach age 70.5 you must take a required minimum distribution (RMD). The RMD starts at 3.65 percent of the plan balance the first year and rises a bit every year, reaching 5.13 percent in year 10, 8.33 percent in year 20, and so on.
Those RMDs someday will be clobbered by estate taxes. But the real villain is what’s called income in respect of a decedent (IRD): the amount in your plan when you die. It’s double taxed.
RMD (while you are alive) and IRD (when you die) are designed to literally, but legally, steal your plan dollars. Can you beat these two tax bandits? Absolutely.
Roth IRA to the Rescue
To illustrate how a Roth IRA can help defeat the double-tax monster, consider married taxpayers Joe and Mary. First, a few basic rules concerning a Roth IRA:
• A rollover can be made from a traditional IRA, or another qualified plan such as a 401(k), to a Roth IRA.
• The full amount rolled over to the Roth IRA is taxed as ordinary income at the time of the rollover. This immediate tax is why so few Roth IRAs are created. The rollover can be made at any age without penalty.
• After Joe dies, Mary can perform the next rollover from Joe’s IRA to a Roth IRA. Mary now owns the Roth IRA and can take income-tax-free distributions as she pleases. Since no RMDs are required, the funds continue to grow tax-free for as long as Mary lives.
• At Mary’s death her estate includes the Roth IRA, subjected only to estate taxes.
• Mary makes her three children the beneficiaries of her Roth IRA. The kids have two distribution choices: The Roth IRA account must be completely distributed within 5 yr. of Mary’s death; or the funds can be paid out annually (as RMD) over the life expectancy of the beneficiaries, beginning the year after Mary dies. All distributions are income-tax-free.
Note: Naming your grandchildren beneficiaries allows use of the life-expectancy choice to extend the distributions over two generations, typically 50 to 70 yr. or more.
Now the secret strategy of how to kill the double-tax monster, which we call the Double-Tax Reverse. Here’s how it works.
During Joe’s life he makes Mary the beneficiary of his IRA—all of Joe’s qualified plans would be rolled into this one IRA. Joe, with the help of his advisors, estimates the amount of income tax that will be due when Mary converts to a Roth IRA. For example, consider that this estimated tax will be $1 million. Joe then purchases a $1-million life-insurance policy and names Mary the beneficiary. Once Joe reaches age 70.5, the RMDs can be used to pay the premiums.
At Joe’s death, Mary rolls over Joe’s IRA to an IRA spousal rollover, a tax-free transaction. Mary converts her spousal IRA to a Roth IRA, and is free to name her children, grandchildren or trusts as beneficiaries. Mary then uses the $1-million life-insurance proceeds to pay for the income tax due on the Roth IRA conversion. Yes, the double-tax monster has been slayed.
How many dollars can the Double-Tax Reverse strategy save you, and how much tax-free wealth can it create? The answer depends on your rate of return in the Roth IRA and how long the account funds compound.
Using the rule of 72, if your account funds earn 4 percent, the amount in the Roth IRA will double every 18 yr.; a 6-percent return will reduce the timeframe to 12 yr. As explained above, the account funds will compound for decades.If you have a large amount in your qualified plans, there is an organized way to not only beat the double-tax monster, but to build tax-free wealth for your family. MF
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