So Your Qualified Plan is a Tax Trap

Here’s how to escape


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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), etc?

This is a bittersweet subject. Bitter if you don’t know how to legally avoid the tax-robbing laws that enrich the IRS. Sweet if you implement one or more of the strategies that follow, turning the tables on the IRS and creating (in most cases) millions of dollars of tax-free wealth.

Let’s personalize this article just for you… start by writing down how much you have in your Plan ($_____ ). Now comes the bitter part… extremely bitter if you happen to be rich.

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’re socked with 40% in income tax. Horrified, you watch your $10,000 shrink to $6,000 after the first $4,000 tax bite. When you go to heaven, the IRS feasts again on the remaining $6,000; this time it’s the 55% estate tax. Another $3,300 swallowed by the tax collector. So, your family winds up with a paltry 27%, only $2,700. The IRS gets 73%, or $7,300. Sorry, but that’s the law. Simply put, you lose $73,000 for each $100,000 distributed. Now, multiply 73% by the amount you wrote in the blank above. Sorry, but that’s the potential tax damage to your Plan funds.

In an evil sort of way, 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% double income tax and estate tax. Stop! Take a moment to apply these awful same-if-you’re-dead-or-alive rules to your plan numbers. Most of my clients cringe when they realize the sad 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. In an attempt to personalize what you are about to read, the following are real-life examples of strategies other readers of this column have used. When an example or strategy fits your facts and circumstances, get more information so you too can join the tax-saving and/or 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 fit the facts and circumstances of each individual). But the six basic strategies outlined below account for 90% of the strategies actually used for real-life readers of this column.

Strategy 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 61-year-old reader turned $135,000 of after-tax plan funds into $1.2 million in his ILIT… all tax-free.

A 64 year-old reader 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 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 71-year-old widower got $2 million into his ILIT using only $176,000 in after-tax plan funds.

Strategy 3: A Subtrust does the same trick as an RPR, keeping 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 a RPR—are about 20% higher 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 4: Boost the annual average rate of return of your plan funds to more than 15% 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. (As a side note, the giant insurance company AIG, and Warren Buffett’s Berkshire Hathaway Inc. both invest in LS.)

Strategy 5: If you would like to make a significant contribution to charity, either during your life or upon death, there are many ways to use your plan funds to enrich your favorite charity without reducing the amount that will go to your heirs.
You’ll love what Ken, a reader from Kansas, 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 2) to buy $3.8 million worth of second-to-die life insurance in an ILIT. His 401(k) invested a portion of its funds in LS (Strategy 4) to boost its income. When Ken and his wife both get hit by the final bus, 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 6.

Strategy 6: Make sure your professional advisor sets your plan up to take advantage of the new Stretch IRA rules when you go to heaven. 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 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) where you can be reached. Include the total amount in all of your plans combined, then fax to me (Irv) at 847-674-5299.