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Traditional IRA: Double Tax
Federal Estate Taxes &
State and Federal Income Taxes
Double Taxation: 75% IRA Tax
This tax surprise is the double tax of your IRA that can be demanded upon a tax-deferred IRA and on a qualified plan asset upon passing away. This is providing, of course, that you do have an estate tax problem at the time of your death. The death tax exemption is pretty generous in 2011 and 2012 at $5M, but who really expects to pass away before 2013? The exemption in 2013 and beyond is not nearly as advantageous and if you have over $1M you likely need to do some planning.
When you pass away with income that defers your taxes, the IRS demands to be paid all income taxes that are due. These taxes are on the entire postponed balance. In addition, upon death with an estate tax problem, the IRS will want the estate taxes that are also due. Let's say you die in 2013 or later. As it stands, anything that exceeds $1 million will be taxed at 55% at the federal level and if you reside in a state that has an estate tax, an additional 5 to 10% can be added on. For the sake of simplicity, we will use 50%. Keep in mind that in a real life case, the financial outlook would be less desirable than presented.
Let's take a look at someone in 2013 who has an estate tax difficulty as well as an IRA of $2,000,000. $500,000 of the IRA will be passed on to the beneficiaries with double taxation imposed.
| Balance of IRA Account at Passing Away | $2,000,000 |
|---|---|
| Federal Estate Tax | ($1,000,000) |
| State and Federal Income Taxes | ($500,000) |
| Total Taxes | ($1,500,000) |
| IRA REMAINING AFTER TAXES ARE PAID | $500,000 |
Most people are not knowledgeable about the double taxation and this financial outlook is sobering. But don't take our word for it, ask your accountant. You may be shocked and annoyed that your CPA never mentioned it. He does not get paid enough to give you this type of foresight.
There is a strategy that can be used to protect your assets which is to Liquidate (sell) and Leverage (maximize your money) to reduce your taxes.
Withdrawing Annualy from Your IRA and Buy Insurance Inside of an ILIT
This is a nice way of referring to taking methodically taking out yearly income from your IRA or a qualified plan (at the lowest income tax bracket) and then use the cash (after the income taxes are paid) to purchase life insurance inside an irrevocable trust also known as an irrevocable life insurance trust (ILIT).
The question is why would withdrawing from your IRA and then buying life insurance into an irrevocable trust be considered a good asset protection strategy? You would be required to pay income taxes on the money when it is removed. Who wants to pay more taxes now? The entire goal of the IRA was to take a reduce taxes by placing cash into it and then allow the money to continue to accumulate tax free.
The reason for the Liquidate and Leverage method still makes sense for asset protection and tax minimization because it will pass more wealth to your heirs after you pass away than if you simply let your money grow in your IRA. It's true that if you take no action, the asset in the IRA will grow tax free, however, when you die, that asset will be taxed twice, with income (likely at the highest income tax bracket) and estate taxes. We will walk you through the numbers below.
It is possible to stretch an IRA (called a stretch IRA plan); however, the estate tax will still need to be paid. In addition, the beneficiaries would have to sell the IRA and then give the money to the estate taxes that are owed. When this happens, the income taxes and any penalties will be due on the withdrawals which is not good asset protection planning for passing the assets to the beneficiaries.
Growing Money in the IRA vs. Withdrawing Cash Yearly from IRA and Purchasing Life Insurance in an Irrevocable Trust (ILIT)
Let's say an individual is 69 years old and is healthy. He has an $8 million estate and $1 million in an IRA which isn't needed in his retirement years so he wishes to pass this to his beneficiaries. Let's say the following is true:
- The IRA's growth is 6%
- A guaranteed Defined Benefit from the life insurance policy was bought in the ILIT (irrevocable life insurance trust) and its value is $1,386,000
- A 40% tax bracket for both federal and state taxes
- After 2013 the man passes away
| Age | To Beneficiaries AFter Income & Estate Tax (if not PROACTIVE) | IRA After Tax & Defined Benefit w/ Cashing Out and Leverage2 | Difference with Cashing Out and Leverage | (%) Difference with Cashing Out and Leverage |
|---|---|---|---|---|
| 70 | $258,806 | $1,575,603 | $1,316,797 | 508.8% |
| 80 | $486,623 | $1,553,016 | $1,066,393 | 219.1% |
| 90 | $894,610 | $1,512,565 | $617,956 | 69.1% |
| 100 | $1,625,251 | $1,440,124 | ($185,126) | (11.4%) |
The results show that in the first year (age 69 row) the second option is better at protecting his assets by 508%. If the man passes away at age 85 then the second option of the Liquidate and Leverage method has 130% greater returns. This increases until age 100 (that is, if the man passes away at age 100). The only instance when a loss is recognized is if the man lives till 100 years old. The average American lifespan is currently at around 78 years according to insurance mortality tables. So, in conclusion, taking annual distributions from the IRA and then using the money (after income taxes are paid on these withdrawals) to buy a life insurance into an irrevocable trust is a superior method of asset protection.
If the man is married and his wife was 69 years old then a second-to-die policy would be bought into an irrevocable trust and the guaranteed death benefit would accumulate to $2,590,000. This second option of liquidating the IRA and leveraging into a life insurance of an irrevocable trust has 892% greater returns. If the man passes away at age 85 then the returns are 285% greater. If the man passes away at 100 years of age then the returns are 48% greater than simply leaving the money to grow tax-free in the IRA (i.e. if the man does nothing).
If you are in this category, you should be considering the 75% double taxation trap and planning on how to avoid it. By appreciating the simplicity of liquidating your IRA and then leveraging into a irrevocable life insurance trust (ILIT), you can increase the amount of wealth that will be passed to their heirs and protect your assets.
Please call Estate Street Partners today to see how you can maximize your IRA retirement income and pass on your inheritance to your beneficiaries to avoid the double taxation trap. (888) 938-5872
About the Ultra Trust®:
- Part 1 - Estate Street Partners
- Part 2 - What is the Ultra Trust®?
- Part 3 - What is a Trust?
- Part 4 - Asset Protection Plan
- Part 5 - Asset Protection Eligible Assets
- Part 7 - What is Probate?
- Part 8 - What is Estate Tax?
- Part 9 - Medicaid Spend Down Rules
- Part 10 - What is the Ultra Trust®?
- Part 11 - Irrevocable Trust Benefits
Read more articles on irrevocable trust asset protection:
To learn more about irrevocable trusts and senior elder care visit:
Managing Director, Estate Street Partners, LLC
Mr. Beatrice is an asset protection, award-winning trust and estate planning expert.
Estate Street Partners, LLC
Uncompromising, Alternative and Exclusive Estate Planning & Wealth Management for an Accelerated Chartered Roadmap to Financial Success
71 Commercial Street #150, Boston, MA 02109
toll-free: 888-93-ULTRA (888-938-5872)
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