MAXIMIZING YOUR IRAS AND QUALIFIED PLAN ASSETS By John Davenport I am a tax attorney and investment professional and I have a mission – Don’t let retirees die with IRA and Qualified Plan assets. For those of you not familiar with the term “Qualified Assets,” this includes 401(k) plans, 403(b) plans, tax-sheltered annuities, and 457 plans. These accounts are one of the few tax shelters remaining for most Americans, and they are great ways to accumulate wealth for retirement. However, IRAs and Qualified Plan accounts are the “WORST” assets to die with. Why? They are triple-taxed assets. These plan assets are subject to federal estate tax, federal income tax, and state income tax. With estate taxes currently at 46% and rising to 55% by 2011, your heirs, presumably your children, could pay upwards of 60% to 80% of these assets to the government in tax. A large portion of America’s wealth is sitting in retirement programs and unfortunately most Americans are unaware that that they have a silent beneficiary on these accounts and that is the IRS. Furthermore, the IRS is a majority beneficiary. I call it the “IRA Tax Trap.” At age 70 ½ Americans with these assets are required to begin minimum income distributions from these accounts. Under the Economic Growth and Tax Reconciliation Act of 2001, Americans are only required to withdraw approximately 3% of their retirement assets beginning at age 70 ½. This was reduced from approximately 5%. Good news – more of your retirement assets can continue to grow tax-deferred thereby allowing the earnings to compound on themselves and ultimately leading to more wealth to pass to your heirs. Sorry to disappoint you but this is not good news. It simply provides a larger account for the IRS to tax at death. However, there is good news and it comes in two parts. First, you can beat Uncle Sam at his own game and effectively help eliminate the IRS’ involvement when passing these assets to your heirs at death. Second, and more importantly for most Americans, retirement plan assets represent the most opportunistic asset for creating family wealth. The challenge for Americans with significant retirement assets is to learn how to maximize the benefit of these assets in retirement, first for themselves and then for their heirs. Let me share one very important method for helping to maximize the benefit of your retirement assets while eliminating Uncle Sam. You need to understand that, if you or you and your spouse are reinvesting your earnings back into your retirement accounts, you are effectively making an unconscious investment for those who will eventually inherit your retirement accounts; your heirs. The question then begs itself – Is it the right investment for your heirs? How do we judge a good investment? There are three primary factors in judging a good investment. These include rate of return, safety, and most importantly, how the investment is taxed. For example, let’s presume there was a hypothetical investment that returned 30% over one year that was guaranteed without any market risk at all. Sounds good doesn’t it? But, what if that same investment was taxed 70 to 80 cents on the dollar. Then, it’s not a good investment at all. Now, take a look at your own retirement assets. Perhaps they’re earning an average of 10% per year. However, if those earnings were projected to be taxed at 60 to 80 cents on the dollar then it’s not a good investment to leave to your heirs. There are other methods of leaving assets to those we love and I call them the “Wealth Maximization Method™” or “Wealth Max.” One method is to withdraw your excess earnings and invest them in an alternative vehicle that I call a “Maximized IRA Trust.” Why a trust? Because the assets held by the trust are held outside of your estate and are, therefore, not subject to estate tax. These assets are also not subject to income tax to your heirs. They are pure cash assets for your heirs. But what vehicle do we use inside the “Maximized IRA Trust?” There is only one vehicle in America today that provides proceeds that are both estate and income tax exempt – trust owned life insurance. Typically, we use joint life or survivorship life insurance payable upon the death of the last surviving spouse. Traditional IRAs would also be payable to your heirs at the death of the surviving spouse. So the timing of the proceeds is the same in both cases, however the amount payable is quite different. For example, let’s take a hypothetical 70-year-old married couple with an IRA worth $1 million taking the 3% mandatory minimum distribution from this asset. Assuming the IRA is earning an average of 8% per year, this would result in an average of 5% excess earning per year or $50,000. When the couple reinvests the excess in the IRA, this is ultimately an investment for their heirs. Unfortunately, it’s a bad investment. As an alternative, the couple could withdraw the $50,000 of excess earnings that they do not depend upon for income, and reinvest these proceeds after tax into the “Maximized IRA Trust” funded with joint life insurance. For this 70-year-old client, one premium payment of $50,000 could immediately purchase $4 million tax-free for their heirs. Since their traditional IRA is fully taxable, on an equivalent pre-tax basis, the new “Maximized IRA” would be worth at least $8 million dollars (based on minimum combined estate and income tax of over 50%). This is the IRA to pass to your heirs. Once in place, the traditional IRA is expendable; in other words, there is no requirement for dying with this asset since the government will take the majority in tax. Consequently, we suggest to our clients that they take more than the minimum distribution as income and either consume it for themselves, gift it to their children and grandchildren, or reinvest the proceeds in something more tax friendly for their children. Finally, many clients decide, at the death of the surviving spouse, to donate the IRA to a charity of their choice or a family foundation. This choice effectively eliminates Uncle Sam. The result is the parents receive more benefit from their retirement assets in the form of income they never would have received, the heirs receive more tax-free wealth than the parents would have made in the market, and the IRS receives nothing directly. Finally, the parents get to direct the resulting IRA proceeds at death to the charity of their choice. This is an example of how to effectively use your IRA and Qualified Plan assets in retirement. Don’t let the IRS take the majority of your IRA and Qualified Plan assets. Turn those assets into a “Maximized IRA Trust”. This strategy is not for everyone, but you may be able to do it without any adverse impact on your cash flow or quality of life in retirement. The failure for most Americans is not taking the time to consider the alternatives. I’ve never understood why Americans work 20, 30, or 40 years to build wealth and do not take a modicum of time to understand how to make the most of it for themselves and the people they love. Beat the IRS at its own game – understand the alternatives and make an informed decision. Otherwise you are giving your hard-earned money away. John Davenport is the Founder and President of Davenport & Associates, Inc., an independent family wealth planning firm for high net worth couples with offices in New York and Connecticut. John is the creator of the “Wealth Maximization Methodology” which earned him a 2006 Forbes Enterprise Award. John can be reached at jf.davenport@wealthmax.net. John is a registered representative of SII Investments, Inc. The tax and legal information on this statement is merely an overview of our understanding and interpretation of the current income tax laws and regulations, and is not meant to be exhaustive. This information is general in nature and should not be construed as tax or legal advice. SII Investments does not provide tax or legal advice. Please consult you tax and legal advisor for guidance regarding your particular situation before making any changes. Copyright © Davenport & Associates 2007. Securities and advisory services offered through SII Investments, Inc. (SII), member FINRA/SIPC and a Registered Investment Advisor. Davenport & Associates, Inc. and SII are separate and unrelated companies. SII Privacy Policy | Important Consumer Information