Are you a high net worth taxpayer (irrevocably in the highest income tax bracket and highest estate tax bracket)? And one of your significant assets is a large amount ($1 million or more) in a qualified plan: like an IRA, 401(k) plan, profit-sharing plan or similar plan (Plan)?
Yep! Those big dollar numbers in your Plan sure sound good. But did you ever do the dreadful tax math? Let’s do it together. To make it easy, suppose you take one dollar out of your plan: the IRS gets 35 cents in income tax -- 65¢ left. When you go to the big business in the sky, the IRS socks you again. This time for 55 percent (using 2013 rates) of the 65 cents for estate taxes -- another 35 cents down the tax drain.
Let’s summarize. The double tax monster gets 70 cents. Sorry, your family only gets a paltry 30 cents. Chances are Congress will change the tax rates -- raising or lowering the after-tax results. But one thing is certain, the double-tax monster will be well fed.
How much will the double-tax cost your family?
Stop! Take a moment to guesstimate your tax loss. For example, you have $1 million in your Plan: The tax collector gets $700,000, your family $300,000. A true tax tragedy.
Wait, there’s more bad tax stuff. Your state of residence (except for the few tax-free states) gets an additional piece of the tax action. Of course, over time, your Plan investments should grow. That growth only adds to your tax pain.
Adding insult to injury
Let’s follow the Plan money: first, during your life and again when you get hit by the final bus.
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 ½ you must take a “required minimum distribution” (RMD), starting at 3.65% of your Plan balance the first year. The RMD rises a bit every year, reaching 5.13% in year 10, 8.33% in year 20, etc.
By now you know the drumbeat, those RMDs will someday be clobbered by estate taxes. But here’s the real villain: it’s called income in respect of a decedent (IRD). What is IRD? It is the amount in your Plan on the day you die. It’s double taxed.
Simply put, RMD (while you are alive) and IRD (when you die) are designed to literally (but legally by the tax law) steal your Plan dollars.
Can you beat these two tax bandits?... A loud ‘YES’. Unfortunately, the how-to-do-it seems like a secret because few professionals know how. The rest of this article shows you the “how-to” road to follow for the situation that comes up the most in practice: a married taxpayer (Joe) married to Mary.
Roth IRA to the rescue
A Roth IRA is the promised land for Joe and Mary to destroy the double-tax monster. The best place to start is with a few basic rules concerning a Roth IRA.
1. A rollover can be made from a traditional IRA or another qualified plan like a (401(k), profit-sharing, pension and the like) to a Roth IRA.
2. The full amount rolled over to the Roth IRA is taxed (as ordinary income) at the time of the rollover. Ouch! This immediate tax is the reason so few Roth IRAs are created. The rollover can be made at any age without penalty.
3.After Joe dies, it is Mary who does the next rollover from Joe’s IRA to a Roth IRA (as explained later in the article). Mary is now the owner of the Roth IRA and can take income tax-free distributions (or not) as she pleases. Since no RMDs are required, the funds continue to grow tax-free for as long as Mary lives.
4. At Mary’s death the Roth IRA is included in her estate and subject only to estate taxes. (This estate tax can be, in effect, eliminated by proper planning, but is not the subject of this article.)
5.Mary makes her three children the beneficiaries of her Roth IRA. The kids have two distribution choices: (a) The Roth IRA account must be completely distributed within five years of Mary’s death; or (b) the funds can be paid out annually (as RMD) over the life expectancy of the beneficiaries starting the year after Mary dies. Of course, all distributions are income tax-free.
NOTE: Making your grandkids beneficiary allows use of the life expectancy choice to extend the distributions over two generations (typically 50 to 70 years or more).
And now the secret strategy of how to kill the double-tax monster
We call this strategy the “Double-Tax Reverse.” Following is how it is done.
1. During Joe’s life (Joe can be any age)
(a) Joe makes Mary the beneficiary of his IRA (all of Joe’s qualified plans would be rolled into this one IRA)
(b) Joe (with the help of his advisors) estimates the amount of income tax that will be due when Mary converts to a Roth IRA (Say the estimated tax will be $1 million).
(c) Joe buys a $1 million policy on his life, naming Mary the beneficiary.
NOTE: Once Joe reaches age 70, the RMDs can be used to pay the premiums.
2. At Joe’s death
(a) Mary does a rollover of Joe’s IRA to an IRA spousal rollover, which is a tax-free transaction.
(b) Mary converts (it can be all or only part of the funds) her spousal IRA to a Roth IRA. Mary is free to name her children, grandchildren or trusts for their benefit as the beneficiaries of the new Roth IRA accounts.
(c) Mary receives the $1 million insurance proceeds from Joe’s policy tax-free (no income tax, no estate tax). Mary uses the policy proceeds to pay for the income tax due on the Roth IRA conversion.
Substitute your name, your wife’s name and the estimated amount of your Plan funds in the above example. You enjoy three tax victories: (1) You indeed kill the double-tax monster -- no income tax when the Roth IRA conversion is done; (2) a tax-free piggy bank for your spouse for life; and (3) tax-free distributions to your heirs for one (or more) generations.
Break out the champagne.
How many dollars will the “Double-Tax Reverse” strategy prevent from being lost to the IRS? Plus how much tax-free wealth will be created? Of course, the answer depends on your rate of return in the Roth IRA and how long the account funds have to compound. To help you answer the questions think about this: Using the rule of 72, if your account funds earn 4%, the amount in the Roth IRA will double every 16 years, if a 6% return doubling would only take 12 years. As explained above, the account funds will compound for decades.
What’s the result? Instead of losing about 70% of your Plan fund to the IRS ($1 million turns into $300,000 after-tax), your $1 million will grow to $2 million (doubles once); $4 million (doubles twice), well you get the idea. And every dollar is tax-free.
Be smart. Look into a “Double-Tax Reverse.”
One thing should be clear: No attempt is made in this article to cover every possibility, nuance or result for the subject covered. But it should be just as clear that if you have a large amount in your qualified plans, (whether married or single), there is an organized way to beat not only the double-tax monster, but legally avoid any tax (no income tax, no estate tax), while building tax-free wealth for your family.
IRVING L. BLACKMAN has been practicing accounting and law more than 50 years, specializing in wealth transfer, business succession and valuation. He was a founding partner of Blackman Kllick Bartelstein LLP, CPAs, one of the largest accounting firms in the country, and is a member of the Illinois Society of CPAs, American Institute of CPAs and the American Speakers Association, among other organizations. Blackman has authored 21 books on taxation and penned hundreds of articles for trade publications. His company, Tax Secrets of the Wealthy, is headquartered in Naples, FL. He may be contacted at (847) 674-5295 or Irv@IrvBlackman.com.