There are many types of qualified plans: Pension, profit-sharing, 401 (k) and IRAs are the most popular. True enough, qualified plans are a great tax strategy if (1) you ultimately need the plan funds for retirement, (2) you are in a low tax bracket when you take the funds out of the plan or (3) your estate is not large enough to kick up an estate tax problem. Perfect for over 90 percent of American taxpayers.
But what happens if you are in the highest income tax bracket (about 40 percent combined for federal and most sates) when you retire and you have an estate tax problem (say the highest bracket of 55 percent, using 2011 rates)? Sorry. The IRS has you in a tax trap. No matter when the funds are taken out of the plan (during your life or after your death), the IRS gets 73 percent of the dollars in your qualified plans. Your family only gets 27 percent (29.25 percent if you are a Florida resident because Florida has no income tax.) The tax trap has been sprung. A tax travesty!
Is there any way out of the trap? Actually, my network of working-together professionals has developed several strategies. The one we use most often is called a “subtrust.”
Here’s a typical example of how a real client used a subtrust. Joe and his wife Mary (from Michigan, but winter in Florida) are both 60 years old. They needed $3 million of second-to-die life insurance to solve their estate tax problem. The premium cost was $33,600 per year; a bit more than Joe wanted to spend. Joe’s profit-sharing plan (Plan) has $400,000 in it. Joe sadly understood that his $400,000 would only net his family $108,000 ($400,000 times 27 percent).
Here’s what we did. We set up a subtrust as part of the Plan. The subtrust will pay the annual premium after receiving the funds from the Plan. Since the policy is actually an asset of the Plan, the annual premium payment is a tax-free transaction.
When both Joe and Mary go to the big business in the sky, their family will receive the full $3 million in policy proceeds. No income tax. No gift tax. No estate tax. The subtrust tax strategy, in this case, actually turns $108,000 of after-tax dollars into $3 million of tax-free dollars (actually more because a portion of the original $400,000 profit-sharing plan funds, plus earnings, will still be in the plan).
If you have $300,000 (or more) in one or more qualified plans and have an estate tax problem, you are in a tax trap. Want to learn more about subtrusts and other strategies than can get you out of the qualified plan tax trap? Send me (Irv Blackman) a fax at 847-674-5299: include (1) your name and birthday; (2) same for your spouse; (3) total amount in all of your qualified plans: and (4) all phone numbers (home, business and cell) where you can be reached. Please write “subtrust” at the top of the page.
Irv Blackman is a certified public accountant who lives part-time on Marco Island and specializes in estate planning, business succession and asset protection. E-mail him at firstname.lastname@example.org or call 417-9732. His Web site is taxsecretsofthewealthy.com.