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Avoid The 75 Percent Tax Trap.

By Roccy M. DeFrancesco, JD, CWPP™, CAPP™ - Email Editor

Date : April 22, 2008

Last week John Dietz talked about dealing with your retirement assets, more specifically ERISA. ERISA court challenges now affect the employer as well as the employee consequently creating an unstable environment. Some see a Pandora’s Box of retirement tools opening to future litigation and potentially changing legislation.

I applaud John for touching on the crossroad question in light of the last newsletter.. From the desks of our many multifaceted disciplines, in law, accounting, and Asset Protection we now ask, is your current plan the best way to build wealth for retirement?

The Tax Dilemma

What if I told you that a million dollar IRA or 401k could be taxed at 75% unless you implement proper planning? Sounds crazy but there are hundreds of thousands of clients walking around with this problem and they don’t even know it. That assumes you do not live in California where you would owe an additional 9.3 percent which would then push the tax to approximately 85%.

What are we talking about, a one million dollar IRA ending up to be 250K or less?

It is now time for you to research and determine if you have the double tax dilemma with money in a qualified plan or an IRA. If you have this double tax dilemma, you need to act in short order to mitigate the problem to make sure the maximum amount of wealth is kept in your family and not given to the IRS. It is most likely that you can increase not only the security of your retirement accounts, but the monetary value as well.

What is the 75-85% tax trap?

If you have an estate-tax problem when you die AND money in an IRA, or qualified retirement plan, that money can be taxed between 75-85% at your death. I am saying CAN instead of WILL because if you were married that money will likely pass to your spouse who then will have the tax problem.

The tax trap comes into play because not only does the IRS want estate taxes at your death, but the IRS also wants the income taxes due on your deferred money.

Remember, the reason you use an IRA or a qualified retirement plan is so you can build wealth in a more tax-favorable manner due to the fact that you can invest money into such vehicles with pre-tax dollars and have tax-deferred growth (no dividend taxes or capital gains taxes are due annually in such accounts).

Therefore, when you die, your estate will be valued; and if there is an estate tax problem and assets with deferred income taxes due, the IRS will collect both, and the taxes will, in fact, be between 75-85% of the value of such assets.

When most people with estate tax problems and money in income-tax-deferred accounts hear about this tax dilemma, they usually get depressed and wonder why they ever deferred the money in the first place.

Readers need to understand that this topic, in and of itself, could merit its own 100+ page book. My intent with this newsletter is to make readers aware of the problem.

The best way to explain the 75-85% tax trap is with an example.

Example

Dr. Smith has a $5,000,000 estate, a $1,000,000 IRA, and lives in a state with a 5% income tax. Assume Dr. Smith dies after his spouse and with an estate tax problem. What taxes will be due on the IRA?

IRA	$1,000,000
Estate Tax:	($550,000)
Income Taxes (State and Federal)*	($250,000)
Total Taxes	($800,000)
TOTAL IRA ASSET AFTER TAX	$200,000

*The exact calculation of the income tax due in the above example is quite complicated and the $200,000 number used is an approximation. Also do not forget that the estate tax in 2011 will revert back to 55%.

If you have no state income tax, the taxes due will be approximately 70%. If you live in California, where the state income tax is near 10%, the taxes due will be approximately 85%.

To some, this will be counterintuitive, since many readers have always been under the assumption that it is good to defer income into IRAs/retirement accounts. Look at the following example, which illustrates the taxes due and how the problem grows as your IRA grows.

The following chart assumes the client has $500,000 in an IRA, has an estate tax problem when he/she dies, and lives in a state with at 5% income tax.

	Start of Year	6.00%	Year End	To Heirs After 80%
Age	Balance	Growth	Balance	Income & Estate Tax
60	$500,000	$30,000	$530,000	$106,000.00
65	$669,113	$40,147	$709,260	$141,851.90
70	$895,424	$53,725	$949,149	$189,829.90
75	$1,198,279	$71,897	$1,270,176	$254,035.20
80	$1,603,568	$96,214	$1,699,782	$339,956.40
85	$2,145,935	$128,756	$2,274,691	$454,938.30
90	$2,871,746	$172,305	$3,044,050	$608,810.10
95	$3,843,043	$230,583	$4,073,626	$814,725.20
100	$5,142,859	$308,572	$5,451,431	$1,090,286.10

It took you 30+ years to amass $500,000 in your IRA at age 60. You were lucky enough to have it grow to over $2,000,000 at age 85. Now, when you die, 80% of that money will go to the government via income and estate taxes.

The above chart is not technically accurate. It has been skewed intentionally to drive home how painful the double tax can be at your death. It is skewed because I did not take out the required minimum distributions the client would have been forced to take at age 70½.

In this example, the client will be forced to take a taxable distribution of $32,679.71 at age 70½ if we assume his wife is the beneficiary and is the same age as the primary IRA owner. This happens annually to millions of people, and the forced distributions increase every year as people get older. When people turn 70½ and their financial planner or CPA says to them that they must start taking money out of their IRA, they usually become upset and wonder why such a stupid rule even exists. Then they will look back at their decision to aggressively fund a tax-deferred retirement plan and will wonder if that was really a decision that can cost their heirs hundreds of thousands of dollars in wasted taxes.

While this topic might make you cringe and question why you funded a qualified retirement in the first place, sticking your head in the sand will do nothing but help the IRS profit at your death. With a little education on the potential solutions (see next week’s newsletter) you will learn how to really supercharge the amount of money you can pass to your heirs and reduce the amount of money paid to the IRS.

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