While you’re alive, a qualified retirement plan can be the best place for you to put your money. But, too often, those plans get subjected to the weight of very heavy taxes after your death. “Qualified plans are the best place to accumulate money during life,” says Richton C. Appel, vice president of Advanced Strategies Group in Southfield. “However, it’s the worst place to have money when you die.”
Smart Business talked to Appel about how to make sure your heirs are well-protected after you’re gone.
Why is a qualified plan not good after death?
You get tax-deferred growth using pre-tax dollars to build wealth inside the plan but at death the account balance is included in the taxable estate and there’s ordinary income tax on distributions to beneficiaries. Death benefits in the plan, if any, are subject to tax because of Income in Respect of Decedent.
What does pension rescue provide?
The pension rescue strategy provides several benefits including current life insurance protection, restoration of lost transfer costs to the heirs, removal of assets from the qualified plan itself, increased estate liquidity and participant benefits from non-taxable attributes of life insurance.
How does it work?
The qualified plan purchases a life insurance policy and is named the beneficiary. The policy is typically funded over approximately five years and the participant reports the reportable economic benefit (REB) on his or her tax return. The policy is removed from the plan at the optimum time by either a taxable distribution to the participant or is purchased from the plan. The policy is then gifted or sold to an irrevocable life insurance trust to remove it from the taxable estate.
The pension rescue strategy offers tremendous opportunity to provide estate liquidity at death to pay the estate taxes that will be due and at the same time preserve assets so that they can transfer to children without having to be liquidated. This is for people who have done very well over the years and have set aside a substantial retirement fund, so that there is more money in the plan than is needed for their lifetime. This excess money in the plan is only going to be subjected to a substantial estate tax burden, which is a tax most people definitely want to avoid.
How much of a difference can a pension rescue make?
To illustrate how the numbers can work to achieve the goal of preserving more of your life’s work, let’s look at a 68-year-old person who has $6.8 million in a qualified plan. Assuming 6 percent growth and reflecting the required minimum distributions until age 85 which we’ll assume is when death will come only $4 million will be transferred to the heirs; that’s from a date-of-death balance of $10.5 million. That’s after estate taxes of about 45 percent and income taxes of 30 percent to the children from distributions from the inherited IRA over their lifetimes.
Now, if the plan purchased a $5 million life insurance policy, with premiums of $312,538 for five years, and then distributed out to the participant in the 11th year at a time when the cash value would be very low in the policy, the results would be very much different to the family. Assuming again that death occurs at age 85, the plan will have a balance of $7.9 million after premiums paid and the required distributions.
Reflecting estate tax at 45 percent and the beneficiaries’ 30 percent income tax on the required distributions to them, this provides $3 million from the plan to the heirs, but that’s before adding in the $5 million of life insurance in the irrevocable life insurance trust, which transfers to the heirs income, gift and estate tax-free.
The net plan balance of $3 million and the irrevocable life insurance trust death benefit totals $8 million. The difference between the $4 million transferred to the family without planning and the $8 million employing the pension rescue strategy is just tremendous.
When’s the best time to set up the plan?
The sooner the better. Once you realize that you are not going to consume all of your retirement plan, you know it’s time to rescue it.
RICHTON C. APPEL is vice president of Advanced Strategies Group and a CPA. Reach him at (248) 359-2480 or RAppel@AdvancedStrategiesGroup.com.