Advanced Strategies for Dealing with Tax Consequences of IRA Distributions

THE MARTIN FAMILY—CHAPTER 3 of 3 (Read Chapter 1 and Chapter 2)

This Chapter Involves Multiple Issues with Individual Retirement Accounts (IRAs) and Planning for Tax Consequences

Tom had opened an IRA account early in his career, even before he became the owner of the Berlin, New Hampshire nursing home.  Each year he contributed the maximum to that account and by age 55 that account was valued at $2 million.  It was obviously not just the time value of money which allowed his rather modest annual contributions to grow to such a large value. There was some luck involved.  During one of his summer stints at Winona (after beginning to work for Dick White) he met Tom Shaw, the parent of two campers.  Tom was a very bright and an aggressive stock broker in Portland, Maine. David persuaded Tom to take half of his IRA funds and invest in Ventrex, a local  start-up company  in the biotech industry.  It was a wild ride. Tom’s $10,000 rose to be worth $900,000, a 90 times multiple.  However, Tom did not sell the stock until after its magnificent rise in value had been followed by a great fall.  Tom sold at $60 a share and then continued to invest the proceeds with wisdom and luck achieving the $2 million in value. The Winona world had paid dividends again.

David saw this IRA balance of $2 million as both a problem and an opportunity.  He was careful to analyze what to do in the context of a family which otherwise had more than enough investment funds to take care of their standard of living for the rest of their lives without considering the IRA account or the business value.

PLANNING ISSUES ASSOCIATED WITH A LARGE IRA OR 401 K ACCOUNT FOR A WEALTHY FAMILY

The arithmetic for a substantial IRA that is not carefully planned for is not favorable.   In Tom’s case  it looked like this:

If Tom died holding the IRA the following happens:

Estate tax value of the account                                                   $2,000,000

Less: Estate tax at 55%                                                                  (1,100,000)

Balance to heirs                                                                                    900,000

Less: income tax required of heirs receiving distributions

From the IRA account   (40% Federal and state tax rate)          (360,000)

Balance for the family                                                                         $540,000

Percentage of the account received:        27% (FAMILY)                           73% (GOVERNMENT)

Amount received:                 $540,000 (FAMILY)             $1,460,000 (GOVERNMENT)

This is not a pretty picture no matter what tax rates are used. It is simply double taxation at its worst.

The result is the same if Tom drew down the whole account over time having to pay income tax while doing so (the 40%) and did not spend these funds during his lifetime so that the remaining funds would subject to the 55% estate tax at his death.

Each family’s situation is different and solutions have to be tailored to the family finances and most importantly, their wishes, which sometimes preempt tax considerations.

David showed these numbers to Tom and Mary who were appalled at the result. having previously thought that IRA accounts were the best type of investment vehicle for them and their family.  David did not really want to shock them but needed some of their preliminary thoughts before he suggested  planning options appropriate for them.  In this brief conversation it was clear that Tom had no appetite for paying any tax earlier than necessary which eliminated the option of a Roth conversion.  Tom and Mary also stated that they had no meaningful charitable interests which eliminated the use of a charitable contribution in the IRA planning.   This helped David reduce the number of realistic options of dealing with Tom’s IRA.

A week or so later David presented Tom and Mary with the following options:

OPTION A- the annuity option (eliminates one tax):

Tom could use the $2 million in the IRA account to purchase a single premium annuity on his life ( he did not want a joint and survivor annuity). Each year the approximately $180,000 distribution from the annuity to the IRA and then to Tom would be subject to income tax (no penalty as Tom was over age 59 ½)  and if all distributions were spent no IRA/annuity funds would ever  be subject to estate tax, thus saving the $1,100,000 noted in the example above. (an annuity by its terms has no estate tax value at the annuitant’s death).  If Tom and Mary doubted that they would use all the $180,000 each year a complementary strategy would be to use a portion of the annual distribution to purchase life insurance on Tom through his irrevocable life insurance trust.  That life insurance would have the dual purpose of protecting the family from loss of economic value should Tom die prematurely or give the family extra value if he survives to an old age.  Here the arithmetic is as follows:

The amount of the IRA distribution received each year                                                    $180,000

Less: Income tax @ 40%                                                                                                            (72,000)

After tax funds available                                                                                                           108,000

Annual premium on a $2 million policy                                                                                    50,000 est.

Balance for life style spending or to purchase a higher

amount of life insurance.                                                                                                           $58,000

OPTION A SUMMARY WITH INSURANCE AND TOM LIVING 5 YEARS

Amount of the account received by:

Family: $2,290,000 ($2,000,000 life insurance and $58,000 x5 years)

Government: $360,000 ($72,000 tax x5 years, zero estate tax on Tom’s death)

It is obvious that this option which eliminates the estate tax is a far better result for the family.

OPTION B: Allows more control in addition to eliminating most of the estate tax

Issues with Option A are that the annuity bears the gamble of life expectancy, the lack of protection from inflation, and having nothing left for the heirs unless the life insurance is purchased.  With a healthy person such as Tom the annuity bet may be a good one.  Here, however, is a way to obtain most of the benefits of Option A without  some of the issues.

Tom could take a distribution each year from the IRA, say $200,000. He would pay income tax on that amount at 40% or $80,000 having $120,000 left over to be used, in part, for his insurance trust to purchase say $3 million of second to die life insurance with an estimated annual premium of $70,000. The balance of $50,000 would be spent. The diminishing funds remaining in the IRA would be invested to protect against inflation.  Here the family would receive the $3 million of life insurance proceeds free of taxes and the balance of the IRA account less estate and income taxes.

The tradeoff here is to have more control over the IRA funds compared to having a fixed annuity but the risk of double taxation is present for any balance in the account upon Tom’s death.