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What Are The Solutions To The Double Tax Dilemma?

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

Date : April 29, 2008

Last week we hit upon the unnerving subject of double taxation concerning money in tax-deferred IRAs and 401(k) Plans. You can refresh your memory with the link to the newsletter. This week we focus our subject on some of the solutions that can supercharge your IRA for the maximum benefits in retirement and reduce the amount of money that you duly owe the IRS.

STRETCH IRAs

One solution that works OK if you do NOT have an estate tax problem is a Stretch IRA. Stretch IRAs do just what their name implies, they stretch the time until the income taxes will be due on IRA assets.

With a Stretch IRA, you can name a child as the beneficiary so that the child’s life will be the measuring life for distribution purposes of the IRA. If you die prior to reaching 70½ years old, the IRA will pass to your child/beneficiary, and he/she can allow the money to continue to grow tax deferred in the IRA.

Essentially, you are trying to avoid paying lump sum income taxes on the IRA by using a Stretch IRA. This can work and is a good way to mitigate income taxes due on an IRA at your death.

However, Stretch IRAs do NOT eliminate the estate tax for someone with an estate tax problem. Therefore, if you pass an IRA to a child/beneficiary through a Stretch IRA, your estate will have to deal with the 55% estate tax (after 2011), which is due when passing that asset to the heirs.

The following example is why Stretch IRAs do not work for people with estate tax problems.

If your IRA balance is $1,000,000 when you die, the estate taxes due when passing the IRA to a beneficiary will be $550,000 (remember I am assuming you will die after 2011 when the estate tax will be 55%).

Where do you think the beneficiary is going to find $550,000 to pay the estate taxes? Chances are significant that the money will come from the IRA.

The problem is that the beneficiary will have to pay income taxes upon taking the money out of the IRA to pay the estate taxes; and if the beneficiary is under the age of 59½, a 10% penalty will be levied upon the withdrawal from the IRA.

Where will the beneficiary find the money to pay for the income taxes and penalties upon withdrawing money from the IRA? From the IRA, of course.

This creates a vicious cycle, and is why, generally speaking, Stretch IRAs DO NOT work for clients with estate tax problems, and why, many times, IRA money needs to be “rescued” before a client passes away.

IRA RESCUE

What is IRA rescue? Simply put, IRA rescue is when you take action to mitigate the double tax and creates a scenario where you will pass more wealth to the heirs after all taxes. As stated, IRA rescue is much more important if you have an estate tax problem.

The simplest way to deal with the double tax of money in an IRA upon your death is to find the needed money (other money) to pay for the double taxes that will be levied on the IRA assets.

The “classic” way to “find” money to pay for the taxes due is to plan ahead and fund a life insurance policy owned by an Irrevocable Life Insurance Trust (ILIT). Estate planning 101 says to have clients with estate tax problems buy life insurance in an ILIT because, when the death benefit is paid from the ILIT, it does so income and estate tax-free.

Many people ask themselves why they would want to incur a large life insurance premium just so they can pass IRA assets to a child/beneficiary.

I hear several times a year from clients who put their children through college, gave them a good life, and are not interested in incurring more expenses just so a large IRA balance can pass to the children without expense (meaning without paying the double tax due upon passing the IRA to the children).

I understand the thinking, and most clients who have that mindset end up with the “do-nothing” estate plan. I don’t agree with the do-nothing approach because the only winner is the IRS. The vast majority of clients, when they understand that they can either give their money to the IRS or, with good planning, to their children, usually opt for good planning.

“LIQUIDATE AND LEVERAGE”

You may not have heard of the above term, but in the “industry,” many are familiar with the concept of “Liquidate and Leverage”.

“Liquidate and Leverage” is a very simple concept. You would simply start systematically liquidating your IRA assets (usually you should be over age 59½ so that you do not incur a 10% penalty when withdrawing the money) and gift the money after taxes to an Irrevocable Life Insurance Trust, which will purchase a life insurance policy with a large death benefit. The death benefit will be used to pay for the double tax due on the IRA balance at death.

It’s really that simple. Let’s look at an example.

Dr. Smith is age 60. He has a $5,000,000 estate, which is comprised of a $1,000,000 home, $1,000,000 in various rental properties, a $2,000,000 brokerage account, and $500,000 in his IRA. Assume he is married and has two adult children and four grandchildren. Let’s also assume Dr. Smith earns enough income from the rental properties and the brokerage account that he does not need the IRA money to live on in retirement. Finally, assume Dr. Smith is in the combined 40% income tax bracket (state and federal).

Dr. Smith has identified the double tax dilemma with his IRA money and would like to pass the maximum amount of wealth to his children upon his death.

As one of the solutions to mitigate the double tax dilemma, there is the “Liquidate and Leverage” solution.

Let’s see how the numbers turned out.

You already know the approximate numbers of the do-nothing scenario from an earlier chart. Eighty percent of Dr. Smith’s IRA will go to the government via income and estate taxes at the second spouse’s death. Assume for the following charts that the money in the IRA continues to grow at 6% annually.

What if Dr. Smith were to take systematic taxable withdrawals of $31,500 from his IRA every year and gift that money to an Irrevocable Life Insurance Trust, which would use the money to purchase a large death benefit on his life through a life insurance policy? You’ll notice that the death benefit from the policy purchased in the ILIT starts at $559,000 and increases to $2,081,000 at age 100.

Now let’s compare the do-nothing scenario from earlier to the “Liquidate and Leverage” scenario on the $500,000 IRA.

	To Heirs After 80%	IRA After Tax	Improvement with
Age	Income & Estate Tax	Plus DB	Liquidate & Leverage
60	$106,000	$657,156	$551,156
65	$141,852	$732,138	$590,286
70	$189,830	$834,392	$644,562
75	$254,035	$1,004,660	$750,625
80	$339,956	$1,226,253	$886,297
85	$454,938	$1,484,000	$1,029,062
90	$608,810	$1,705,000	$1,096,190
95	$814,725	$1,904,000	$1,089,275
100	$1,090,286	$2,081,000	$990,714

How did the heirs fare with “Liquidate and Leverage?” Much, much better. $551,156 better at age 60, $886,297 at age 80, and over a million dollars better at age 90.*

* These numbers would apply at the second spouse’s death due to the fact that the IRA balance can transfer to the spouse without taxes at the first spouse’s death. The chart also does not take into account the Required Minimum Distribution (RMD) that will start to come out at age 70½. To incorporate RMD numbers into the chart would be very confusing, and my point with this illustration is simple: by doing nothing, you are not maximizing what you can give your heirs. By using other planning measures, your heirs will be much better off financially at your death.

Is it fair to say that Dr. Smith’s heirs would be much happier if Dr. Smith and his wife sat down with a qualified planner to help him deal with the double tax trap of money in his IRA? What if it were a planner who knew how to implement the relatively simple “Liquidate and Leverage” concept?

Due to space issues, I will have to wait until next week’s newsletter to illustrate how you can use the equity in your home to mitigate the double tax dilemma (as I describe in tin my new book The Home Equity Management Guidebook: How to Achieve Maximum Wealth with Maximum Security (which can be purchased from Trustmakers at a 10% discount by clicking here).

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