Individual Retirement Accounts (IRA’s) and other qualified plan assets (401(k), profit sharing plans, etc.) were designed to help individuals save for retirement in a tax advantaged way. For simplicity, I will refer to all of these types of accounts as qualified plans. The most significant tax advantage of qualified plans is tax deferral. By this I mean that you contribute pre-tax dollars to the qualified plan and the contributions grow tax-free until withdrawn.
At first blush, this tax deferral seems quite attractive, and, in fact, it is. There are endless articles on the “power of tax deferral.” However, the whole story should include a discussion of the income tax liability imposed on these plan funds when withdrawn. By way of example, if the qualified plan has an account value of $500,000, the net after-tax distribution amount (i.e., the spendable amount) is only a fraction of that. Assuming combined federal and state income tax liability of 40%, the spendable portion of this account is $300,000. The good news is that account grows tax deferred until withdrawn, but the future income tax liability never disappears and is tied to your income tax bracket at the time of withdrawal. The IRS will ultimately tax your contributions and will share in the growth of the account.
Qualified plan rules require that you begin taking distributions when you reach age 70½. The percentage of the value of the account required to be distributed starts at 3.65%, increases each year, and does not exceed 7% until age 87. This means that if the average account growth is 7% of the account value, (and the deferred taxable portion) it will peak at age 87, right around average life expectancy.
There is little doubt that children will ultimately inherit the qualified plan account. The only question is what the value of the account (and the taxes due upon distribution to the children) will be. Although there are a number of other, more tax-efficient, options available with proper planning, in the vast majority of the cases I see, the children will withdraw the account value. This means that, after tax, assuming a 40% income tax rate, the children ultimately receive 60% of the account value. Since the qualified plan is included in your estate, there may be an estate tax due, especially where there are significant other assets, but I intentionally omit any discussion of estate taxes for purpose of this article[1].
If you have other assets that provide for your retirement income needs, or do not need the entire minimum distribution amount for your personal income needs, it is possible to provide a greater benefit to the child using a portion of the minimum distribution to fund a permanent life insurance policy designed to provide tax-free funds with which to pay the income tax liability. Insurance may also provide the opportunity to educate the child on the benefit of continued tax deferral since the insurance will replace most, if not all, of the after-tax income the child would receive had he or she liquidated the account. Finally, it is also possible to add a long-term care rider to this policy to provide funds should you ever need long-term care.
Every situation is unique, and adding the life insurance protection may not be the right solution for all. It is, however, an alternative that should be considered, especially when the account owner is healthy.
If you would like more information on this subject, or have a client who might benefit from a discussion about it, please contact Barry Koslow at bkoslow@mkaplanners.com or (781) 939-6050.
Securities offered through Advisory Group Equity Services, Ltd., Member FINRA/SIPC. 444 Washington Street, Woburn, MA 01801 (781) 933-6100.
This article should not be considered as providing accounting, business, financial, investment, legal, tax, or other professional advice or services. It is not a substitute for such professional advice or services, nor should it be used as the basis for any decisions or actions that may affect your business or you personally. This should only be one part of your research. You should seek authoritative guidance from a qualified accountant or attorney before taking any action.
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[1] In Massachusetts the estate tax on estate of $1,000,001 is $33,256 or 3.32% of the estate value.
