Your Qualified Plan Is a Terrible Tax Trap; Heres How to Escape

Do you have a significant amount of money ($400,000 or more) in one or more qualified plans, for example, an IRA, profit-sharing plan, 401(k)? This is a bittersweet subject. Bitter if you don’t know how to legally avoid the laws that enrich the IRS. Sweet if you implement one or more of the strategies that follow, creating millions of dollars of tax-free wealth.

Let’s personalize this article for you. Start by writing down how much you have in your plan ($____________).

Here’s how the tax law robs your dollars. When your plan funds are distributed to you—using a $10,000 distribution as an example—you are socked with 40 percent in income tax, state and federal, if you are in the highest tax bracket. Horrified, you watch your $10,000 shrink to $6000 after the first $4000 tax bite. When you die, the IRS feasts again on the remaining $6000; this time it’s the 55 percent estate tax, using 2011 rates. Another $3300 swallowed by the tax collector. Your family winds up with a paltry 27 percent, only $2700. The IRS gets 73 percent, or $7300. You lose $73,000 for each $100,000 distributed. Now, multiply 73 percent times the amount you wrote above. That’s the potential tax damage to your plan funds. High robbery.

In an evil sort of , the IRS gives you a second chance. If you die before distributing all of your plan funds, your heirs still get hammered for the same 73 percent double income tax and estate tax. Take a moment to apply these same if-you’re-dead-or-alive rules to your plan numbers. Most of my clients cringe when they realize the tax consequences: a stratospheric $730,000 per $1 million of your plan funds are lost to tax collectors.

Now, we are ready for the sweet part—the part that enriches you and your family. Following are real-life examples of strategies other readers have used. When an example or strategy fits your facts and circumstances, get more information so you too can join the wealth-creation fun. All numbers are rounded for ease of reading.

It should be noted that there are actually 12 basic strategies, along with an endless variety of combinations (necessary to make each escape plan exactly fit the facts and circumstances of each individual client). But the six basic strategies outlined below account for 90 percent of the tax-trap-escape strategies used for readers of this column.

Strategy No. 1—Use all or a portion of your plan funds to buy a single premium immediate life annuity (a tax-free transaction). Then, use the annuity amount, which continues for as long as you live, to buy life insurance in an irrevocable life insurance trust (ILIT). For example, a single reader (age 61) turned $135,000 of after-tax plan funds into $1.2 million in his ILIT…all tax-free.

A married reader (age 64 with a 59-year-old wife) created $2.8 million of tax-free wealth in his ILIT with $148,000 of after-tax plan funds. We call this strategy the Junk Money Plan (JMP).

Strategy No. 2—This strategy is called the Retirement Plan Rescue (RPR). It is similar to a JMP. The only difference is that the necessary amount to pay the insurance premium is distributed from the plan each year. A reader (71-year-old widower) got $2 million into his ILIT using only $176,000 in after-tax plan funds.

Strategy No. 3—A subtrust does the same trick as an RPR (keeps the life insurance proceeds out of your estate, but without the need for an ILIT). The insurance death benefits, with the same premium cost as an RPR, are a bit higher (by about 20 percent) than an RPR. Generally, a subtrust is used only for married plan participants. If you are married, it’s an absolute must that you check out how a subtrust might work for you and your family.

Strategy No. 4—Boost the annual average rate of return of your plan funds to more than 15 percent without market risk, by investing in Life Settlements (LS). A public company makes LS available to the little guy. Minimum investment is $50,000 for qualified investors.

Strategy No. 5—If you would like to make a significant contribution to charity, during your life or at your death, there are many s to use your plan funds to enrich your favorite charity without reducing the amount that will go to your heirs.

You’ll love what a reader (Ken) did with his 401(k): Ken’s 401(k) has a balance of $510,000 and Ken plans to contribute an additional $12,000 per year for the next 15 years. He used an RPR (strategy no. 2) to buy $3.8 million of second-to-die life insurance in an ILIT. His 401(k) invested a portion of its funds in LS (strategy no. 4) to boost its income. When Ken and his wife both die, the $3.8 million in the ILIT will be divided between his heirs ($1 million) and charity ($2.8 million). Any balance in the plan will take advantage of strategy no. 6.

Strategy No. 6—Make sure your professional advisor sets up your plan to take advantage of the new Stretch IRA rules when you die. These rules allow you to leave your IRA to younger family members so that distributions are made over their (longer) life expectancy rather than your (shorter) life expectancy. This is a great wealth-creating device (instead of losing your plan funds to the IRS) for your kids and grandkids.

Want more information about this fascinating subject? Just write the words “Plan Info” on your request along with your name, age, address and all phone numbers (work/home/cell). Include the total amount in all your plans combined, then fax Irv at 847/674-5299. MF

Technologies: Management

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