Your retirement plan: tax haven or trap?

By Scott Keffer

Dr. Frederick wondered, “Did I make a big mistake by putting so much of my money into my retirement plan? Is it a tax haven or a tax trap?” “Maybe both.” I said, leaving him a bit bewildered.

Dr. Frederick, a sixty five year old surgeon, is facing what many doctors are, or soon will be facing, the big question of: what to do with their retirement plan moneys. In light of the three year moratorium on the 15 percent excise tax, affectionately referred to as the “success tax,” many are wondering if it makes sense to take large early distributions from their pension balances. Many advisors are advocating larger than normal distributions, but does it make sense? Doing so to avoid the excise tax necessitates paying the income tax now and reinvesting the net proceeds. But how does this compare to leaving the assets in the plan to grow on a tax deferred basis?

Let’s assume that Dr. Frederick has $1,500,000 in his IRA, $500,000 in investments and a home worth $300,000. He is ready to retire and wants $100,000 in after-tax income for life, adjusted for 3 percent annual inflation. If he and his wife follow conventional wisdom, they will withdraw from their IRA first and then from their investment account only if they need it. If they followed this strategy, assuming a 9 percent return in their IRA, in 20 years their IRA would be exhausted. On the other hand, if they funded their income out of their investment account first and then the IRA, in 25 years they would have almost $2,500,000 in their IRA. The power of tax deferral creates an unbelievable difference. Using the IRA last clearly outweighed the option of using IRA dollars first—a Tax Haven.

But, just as important to many is the effect that this will have on their ability to transfer wealth to their children and grandchildren. They are well aware that the IRA balance at death can be subject to three taxes: IRS, estate and excise taxes. These triple taxes have led many to call this “an IRA for the IRS”.

Multiple tax law changes have had a devastating effect by levying more and more taxes on retirement dollars. In 1974, heirs would have received almost $1,000,000 of the $1,500,000. By 1981, their share would have been reduced to about $750,000, and today they could receive as little as $375,000, or 25 percent. Will Rogers said, “The major difference between death and taxes is that death doesn’t change every time Congress meets.” Your retirement plan is also a tax trap, a triple tax trap.

What’s the answer? You need to perform a thorough analysis of your situation before you accept the knee jerk reaction to draw all your dollars out of your retirement plan. First, take a look at your cash flow needs, today and tomorrow. How much income do you need to ensure your financial security? Take your best estimate and add 20-50 percent to it. Second, if you have excess dollars, how can you leave the bulk of them to your heirs?

One interesting option is to create an Enhanced Income Trust and name the trust as the beneficiary of your plan at your death (your spouse’s approval is required). As the only income beneficiary of the Enhanced Income Trust after your death, your spouse will continue to receive income for the balance of her or his life. At your spouse’s subsequent death, the balance passes to charity. And there is no reason that this can’t be your own charity, the Frederick Family Charity.

The results of this option for the Fredericks would be:

• Lifetime income for the surviving spouse.

• No minimum distribution rules on the income to her.

• No estate taxes due at the first death.

• No income taxes until the income is paid out of the trust.

• No estate or income taxes due at the death of the surviving spouse (although the excise tax may be due).

In this scenario, the children would receive nothing. Most will remedy this by transferring a small portion of the plan into an Asset Replacement Trust, funded with life insurance, thus providing the heirs a tax free inheritance equal to the original IRA balance.

With this alternative, Dr. and Mrs. Frederick could enjoy $100,000 yearly after-tax income for their lifetimes, leave the full $1,500,000 value of their IRA to their children and leave over $2,000,000 to the Frederick Family Foundation.

Is your retirement plan a tax haven or a tax trap? It depends. If you don’t analyze the living benefits of your plan in light of your overall wealth, you may make a decision about distributions from your plan that is based on a narrow perspective. The result is the loss of the incredible benefits of tax deferral. And if you don’t take action to plan for the distribution of your plan after death, you risk losing up to 75 percent of retirement moneys to confiscatory taxes.

But with prudent analysis and creative planning, a properly structured retirement plan can provide tremendous benefits for you, your family and your community. You will be able to utilize more of your retirement moneys, leave an undiminished inheritance to your family and provide for the causes which most closely mirror your values.

Scott Keffer is president and founder of Wealth Transfer Solutions, Inc., a legacy planning company in Pittsburgh.