Avoid retirement plan confiscation

By Scott Keffer

“What dilemma are owners of the $11.5 trillion in qualified retirement plans currently facing? Here’s the dilemma: successful individuals, including many doctors, won’t need retirement monies to sustain their lifestyles in the future. Those who have significant retirement balances, often have substantial other monies accumulated outside of their retirement plans. Therefore, their lifestyle needs can come from those other monies. In their minds, their retirement plan monies are earmarked for their heirs.”

“As a result, many only take minimum distributions from their retirement monies to avoid paying income taxes on the distributions. Some even take less than the required distribution and are subject to a 50 percent penalty for under-distribution. Do you know how much was paid in penalties in 1997? $2.4 billion!”

“In addition, two taxes can be levied on retirement monies at the death of the surviving spouse. First, estate taxes: federal and state estate taxes can take up to one-half off of the top. Then, income taxes: the plan balance, after the Federal estate taxes, is subject to an income tax, called Income in Respect of Decedent (IRD). These two taxes can confiscate the majority of your retirement monies. You can lose up to a whopping 70 percent to estate and income taxes. Alternative distribution elections by your heirs can only postpone the tax, but cannot eliminate it.” Dr. Ted Ehrman explained to his colleague Jack, as he took a breath to gulp down more of his coffee.

Despite the fact that Jack was over ten years younger than Ted, they had become good friends soon after they met. Even though Jack had not seen much of Ted since he retired over 18 months ago, Ted began the conversation as if they had just seen each other the day before.

“Qualified plans are one of the worst ways to transfer wealth to heirs!” Ted concluded with a crescendo… and then stopped for more coffee.

Jack was totally surprised—and quite annoyed. He had heard about taxes on retirement plans, but no one had explained it to him. “Are you sure? Where did you hear about this anyway? What can be done?” Jack asked his longtime friend and mentor in machine gun fashion.

Before Ted could even answer him, Jack exclaimed, “There is absolutely no way I want my kids to receive only 30 cents of every dollar I have squirreled away in my retirement plan! I’ve already paid my fair share of taxes! It’s highway robbery!”

“No,” sighed Ted, “It’s capital punishment by confiscation!”

As Ted continued, Jack’s mind wandered. This isn’t fair! I worked hard at saving money, both in my retirement plan and outside. As a result, I don’t really need the monies in my retirement plan for Janie and me to retire. That money was going to go to the kids and grandkids to help secure their future.

“Why don’t I just take it out before I pass away?” Jack blurted out.

“I hate when you interrupt me in mid-sentence.” Ted sighed, remembering that Jack had a habit of doing that. “Weren’t you just listening to what I said?”

Ted continued, “Do you remember when we were sold the idea of putting large amounts of our income into a retirement plan? Although we received an upfront tax deduction and tax deferral, no one pointed out that a retirement plan converts all of the growth inside the plan into ordinary income from a tax perspective.”

“So,” Jack said, “What does that mean?”

Ted continued, “It means that the entire balance will be taxed at ordinary income tax rates when you withdraw it. It means that the amount of tax you will pay on capital gains inside of your plan is almost doubled—from 20 percent to almost …”

“I got it. So, if I take it out before I die, I’ll pay income taxes on both the income earned and the capital gains at a rate of almost 40 percent.” Jack interrupted again. “One tax if I do it now…or two taxes if I wait. What a choice!” Jack lamented with frustration. “So what are my options?”

“Do what I did. Get a written second opinion of your current wealth plan. It will confirm whether you need your retirement monies to live securely—and it will show you what will happen to your retirement monies, and all your assets, when you pass away,” Ted shared. “And it will determine whether you are a candidate for a retirement rescue program.”

Jack was curious. “Tell me how a rescue program works,” he prodded.

“The specialist who set up my wealth preservation plan explained that there are a number of ways you can avoid the double taxation of retirement plans. The strategy that makes the most sense for you depends upon the particulars of your situation. However, let me share what I remember about my program.” Ted’s voice grew more animated, as it always did when he assumed the role of mentor and teacher.

“Currently, I have about $1,000,000 in my Profit Sharing Plan account. The Plan would use my account balance, at my direction, to acquire a specially-designed life insurance policy. It is a policy that is designed to be eligible for valuation adjustments, similar to the way Family Limited Partnerships receive valuation adjustments. The plan would transfer $200,000 a year for five years. Let’s ignore the earnings on my $1,000,000 balance for this illustration.”

“Since the specially-designed insurance policy would pay a death benefit if I were to pass away, each year I would pay a very small amount of income tax on the value of having the death benefit in the Plan—around $6,000 a year.”

“At the same time, I would establish a multi-generational estate tax free trust. It’s the same kind of trust that mega-wealthy families like the duPonts have been using for almost a century. I would use my annual exclusions to make tax free gifts to the Ehrman Dynasty Trust in the amount of $70,000, for a total for $350,000. You didn’t think I’d be able to leave a dynasty, did you, Jack?”

“Then,” Ted continued, “At the end of five years, I would purchase the policy from the Profit Sharing Plan for its fair market value. It’s my understanding that the fair market value of a policy can be determined by using the policy reserve value, which is calculated by the insurance company. This is where the valuation adjustment comes into play: even though I transferred $1,000,000 into the policy, the reserve value is only $350,000. So, I can buy the policy from the plan for only $350,000.”

Ted always talked faster as his enthusiasm grew.

“If I wanted to, the $350,000 inside the plan could continue to grow. However, let’s assume that I immediately withdraw the entire $350,000 from the Plan as a lump sum distribution. A $350,000 lump sum distribution would result in income taxes due of around $140,000.”

“Do you see the impact of this?” Ted questioned. “If I were to take a lump sum distribution of the $1,000,000, I would owe income tax of $400,000, not $140,000. That’s a savings of $260,000—a 65 percent reduction in income taxes paid.”

“Then, I’d sell the policy to the Dynasty Trust to get it out of my taxable estate. My Dynasty Trust would use the $350,000 that I previously gifted to pay me for the policy. That way, I’d receive back all of the annual gifts that I had made to the trust. And, I’ve gifted an asset that will eventually be worth $3 million to my heirs without having to pay gift taxes.”

“Jack, when I pass away, the policy proceeds will be received income and estate tax free by the Ehrman Dynasty Trust. I am going to pass over $3 million to my children and grandchildren—completely free of taxes.”

“Think about that!” Ted prodded. “My Profit Sharing Plan balance would have to grow from $1 million to around $12 million, to net $3 million to my heirs after double taxes. In addition, the monies in my Dynasty Trust are protected—from future estate taxes, lawsuits, divorce and other potential losses—for my children, grandchildren and great grandchildren.”

“Hey Jack,” Ted needled, “What kind of dynasty are you going to leave—25 cents on the dollar or…”

Jack didn’t let him finish. “Okay, okay. Give me the number of your wealth preservation specialist. I’ll call him and see which strategy makes sense for me to avoid retirement plan confiscation.”

Ted, never one to leave a conversation without the last word, shot back, “Make sure you call him today!”

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