Planning For Significant Retirement Accumulations
by James Lange, JD CPA

The following is the text of a lecture which James Lange presented to Pittsburgh Life Underwriters Association. 

The theme that I want to communicate is the power of deferring income taxes. Eventually, I will tie that theme into the benefits of second-to-die life insurance policies. So, you can use the following talk not only as useful information, but also as a tool to help explain the tax and financial advantages of second-to-die policies for certain clients.

The simple premise is that you are better off paying a dollar of tax in the future than you are paying a dollar of tax today. The reason for this is the time value of money. Most everything that I will speak about is an expansion on the theme of the time value of money. Specifically, how to take advantage of the time value of money in qualified retirement plans or IRAs. Though there are certainly a wide variety of differences among the plans, I am going to be speaking in terms that would be common to all qualified retirement plans and other tax-deferred vehicles, including but not limited to IRAs, SEPs, 401(k)s, 403(b)s, defined benefit plans, defined pension plans, and money purchase plans. However, for our discussion today, let's use a 401(k) plan as an example, looking at it from an employee's perspective.

BEGIN EXAMPLE OF A 401(k)

If you or your clients have an opportunity to participate in a 401(k) plan, if you could possibly afford it, I would highly recommend a 401(k) plan as a method of building wealth. Let's start with an easy example. Let us assume that you are participating in a plan that will match part of or match your entire contribution to the plan. Some qualified plans even have a greater than 100% match. Many plans will match fully or partially a certain percentage of your gross pay and then after that anything you would contribute would not be matched.

For example, it might be the type of plan where the employer will match up to 6% of your salary after which you would have an opportunity to make additional contributions that would not be matched. My advice in almost all matching opportunities is to make a contribution at least to the point the employer is matching.

ALWAYS CONTRIBUTE FUNDS THAT EMPLOYER WILL MATCH

In the example where the employer is matching up to 6%, if you contribute 6% of your salary and the employer matches it, there is a 100% return on your investment within one day. You can't do better than that anywhere. In addition, you will not have to pay federal income tax on either the amount the employer pays or the amount that you pay. If a gross salary is $50,000 and the employer puts in 6% or $3000, which is matching your 6%, you'll have $6,000 put away in an account for you and you will not have to pay federal income tax on that $6,000 until you take it out. Assuming you let this tax-deferred money accumulate, that money is going to appreciate or earn dividends and interest or incur capital gains. You will not have to pay tax on any of that money until you take it out. It would be financial folly not to contribute at least as much as the employer will match, even if the employer is contributing only a portion or a percentage of what you are putting in, up to a particular percentage of the pay.

Example

What you get for your $2,160 after-tax dollars:

$3,000 (your money contributed to the plan on your behalf)

3,000 (employer-match portion)

$6,000 (total tax benefit that is invested on your behalf)

ISSUE OF NON-MATCHING FUNDS

Now comes a much tougher question. What if you have the opportunity to make a contribution that the employer will not match. You'll have the same tax deferral feature of not paying federal income taxes on the contribution or the interest, dividends or capital gains until you take the money out. Since it is settled that you should take advantage of all the employer's match, I am only going to compare the consequences of putting money into a qualified plan versus saving that money outside a qualified plan, assuming that there is no employer match.

COMPARISON OF TWO EMPLOYEES

Let's take a look at Chart 1, which illustrates our first example. Here we compare two 30-year-old employees who have an opportunity to contribute a non-matching contribution of $5,000 per year. Let's also assume for discussion sake that the employees will enjoy 2.5% annual raises and will have an opportunity to increase amounts to save for their retirement by 2.5% per year.

Now let's assume that these two people are working for the same company, in the same tax bracket, making the same salary, and choose the same investments. One employee invests his savings in qualified plan, non-matching. The other employee earns the money, pays the income tax on the money, invests the net proceeds, earns interest and dividends on net proceeds, pays the taxes on the earnings, and then accumulates the net after all the taxes.

GO TO EXHIBIT 1

If the first employee who is putting his money in the 401(k) continues to do so through age 70, he will have accumulated $1,577,713 before income tax dollars. His colleague in the same situation, choosing not to use a qualified plan but rather investing outside a qualified plan, would have accumulated $708,073 after-tax dollars.

STARTING TO MAKE MINIMUM DISTRIBUTIONS ON EXHIBIT 1

Please note that the participant in the qualified retirement plan will be required to make distributions from the plan the year following his reaching the age of 70 1/2. Let's assume for our example, that he will be taking out the minimum distribution from his qualified plan because he wants to continue to pay income tax later rather than sooner. Even taking out the minimum distribution, he will have to pay income taxes on all the money he withdraws.

His colleague on the other hand, who has less money, will not have to pay income taxes on money that he withdraws. The colleague will have to pay income taxes on the income from the balance of the money. Let us assume that the non-participant takes out the same distribution as the participant's minimum distribution after adjusting for the participant's income taxes. In this way, their withdrawals will each have the same after-tax purchasing power. For simplicity, we are also assuming that the tax rate will remain unchanged during the whole period. Of course, that assumption isn't legitimate. The old wisdom is that a taxpayer's tax bracket will go down after retirement. I'm not sure this will happen. Particularly if the participant does save in this judicious fashion for his retirement, his tax bracket could be the same or depending on other financial circumstances could conceivably go up, particularly if the tax rates go up. But, let's assume a level income tax rate throughout the entire period.

RESULTS COMPARING AMOUNT SAVED ASSUMING SAME SPENDING LEVEL

You will note in Exhibit 1 that with the same purchasing power, the non-participant will run out of money at age 80. The participant, however, at age 80 will still have $1,354,973 in his plan. It is true, he or his heirs will have to eventually pay income tax on this money, but I would rather have $1.3 million and have to pay income tax than have nothing and not pay income tax. Of course, another way to look at this is that the participant could spend considerably more than the minimum distribution and have an extremely comfortable retirement compared to his colleague who will have not nearly as comfortable a time during retirement. The other option to spending more money is leaving more money to one's heirs.

Exhibit 2 Shows the Cumulative Distributions

Please turn to Exhibit 2 which shows the cumulative distributions. You will note they are the same up to age 80. Then, when the non-participant is out of money, the participant, who has the $1.3 million, will continue to make distributions so his cumulative distribution for his lifetime will be $2,373,820.

I think the accompanying chart is a nice demonstration of the power of the tax deferral.

SPENDING DOWN MONEY IN RETIREMENT

What I would like to do now is switch over to the concept of what moneys retirees or even someone of retirement age who is still working should use for spending money, i.e., living expenses. Let's go back to that first participant and assume that he's taking out the minimum distribution requirement. Let's also assume he has other money saved up which he accumulated the same way his colleague did, in the after-tax environment. Also, let's assume for this discussion that he wants to spend more money than his minimum distribution. He has two choices.

The first choice is to take more money than the minimum distribution, and the second choice is to spend the money that he has already paid income taxes on. To simplify our discussion, for the time being, I'm going to not take into consideration the excess distribution tax and the excess accumulation tax. Now let's go back to my comparing the two alternatives. Choice one would have the same spending power or the same after-tax dollars being spent where first we are going to spend down the after-tax dollars until we run out and then we're going to spend down the pre-tax dollars. In the second alternative, we're going to spend down the pre-tax dollars, and preserve our after-tax dollars. If you're expecting a better result by spending down our after-tax dollars first, you are correct. In fact, this chart illustrate the extent of how much better off you are preserving money in the tax-deferred environment.

PLEASE GO TO EXHIBIT 3

By spending down the after-tax money first, you will have an extra $380,000 at age 80 which includes the identical starting points and identical spending patterns starting at age 65.

The reason for this result is that for the participant to reach $87,000 purchasing power from his qualified plan, he/she must start by withdrawing $109,000 from the qualified plan, pay income tax of $22,000 (using tax formulas with standard deductions and exemptions). Spend the remaining $87,000. The participant's cost, $109,000 before tax dollars.

Comparison: If the participant spends his after-tax money first, then he will only spend $87,000. With the first method, the participant will have an additional $22,000 total funds. He will eventually have to pay these $22,000 in taxes on this money, once he begins to need his retirement money to meet his expenses. In the meantime, the $22,000 can continue to earn additional interest for him.

One issue I will not address but will bring it up as a problem I have encountered is: What if one spouse has all their funds in a qualified retirement plan and the other spouse has all their funds in an after-tax account? If you were the spouse with the after-tax money and assuming you understood these concepts, would you be willing to spend down your money while your spouse was accumulating more money in their retirement plan?

SUMMARY TO THIS POINT

Summarizing our conclusions to this point,

• It is critical to long-term financial health to take advantage of an employer's matching portion.

• It is better to accumulate money in a tax-deferred environment than in the taxable environment.

• When you have both money in the after-tax environment and access to money in a qualified plan, it is better to make spend down your after-tax money before your qualified plan money.

MINIMUM DISTRIBUTION RULES

There is an entire set of rules called the minimum distributions rules, which themselves could be worthy a ten-lecture series. It is beyond the scope of our discussion today, but I wanted to mention that choosing the most advantageous options for the minimum distributions rules is critical.

Also, I want to shatter the myth that recalculating both lives is always the most advantageous because it defers income tax the longest. That strategy might work if the right person dies first and the survivor live for many years. If you guess wrong and the person who you didn't expect to die first does die first, you are potentially hurting the surviving spouse or the heirs.

RETIREMENT PLAN DISTRIBUTION RULES AFTER DEATH

So at this point we have seen the benefits of putting money in a qualified plan, preserving money in a qualified plan, and slowing down the distributions of a qualified plan. Well, the next topic is the use of this qualified plan for not only retirement planning but also estate planning and maximizing the value that a client's spouse and/or children will receive from this qualified money.

Now, let's consider what happens after the participant dies and leaves money in a qualified plan or IRA. The rules immediately come to a fork in the road. If the participant died before 70 1/2, that would be a real shame. All those years of savings in the tax-deferred environment, and now he/she is dead. Well, that is good news for his/her heirs, at least financially, because the heirs will have some attractive options regarding the accumulations.

The general rule is that distributions must be completed within five years. The exceptions, however, dominate the rule. If the spouse is the named beneficiary, the spouse would have the option of making an IRA rollover. If the spouse is younger than the participant, the spouse could keep the money in the tax-deferred environment longer by using his/her own age to determine when and how much money must be distributed from the plan or IRA. If the spouse is older than the participant, the spouse could use the schedule of minimum distributions that the participant would have had.

The second exception, and perhaps the one with some of the most interesting estate planning opportunities is the exception for the non-spouse beneficiary. If the participant had named a younger beneficiary such as a child or grandchild, then the child or grandchild could use their own life expectancy to determine the amount of the minimum distribution. This is not as favorable as allowing a child or grandchild to roll money into an IRA like the spouse, but since the child or grandchild is likely to have such a greater life expectancy, the number of years to keep the tax deferral party going increases the value to the beneficiary significantly.

Let's assume a 68-year-old participant has three separate IRAs, or he separates his plan into three components. In one he names his 68-year-old spouse, in the other he names his 35-year-old child, and in the last one, he names his 5-year-old grandchild as beneficiary to this $100,000 plan.

In the first plan assuming that he dies and his wife inherits the money, she would most likely roll the money into her own IRA and be forced to begin making withdrawals when she turns 70 1/2. These withdrawals would be based on her life expectancy or perhaps her life expectancy and that of a beneficiary. The chart demonstrates that the cumulative distributions to the spouse are a little over $200,000.

If the participant names his 35-year-old son as beneficiary, the 35-year-old son is not allowed to roll it into his/her IRA. The 35-year-old son could withdraw money based on his actuarial age and pay income tax based on the amount of his withdrawal. Also note that the son could take more than the minimum distribution out, but he would have to pay tax on whatever he took out. There would not be a penalty for early withdrawal as is the case with an IRA. Since his actuarial life expectancy is so long, he will be required to take out much less money than the participant or his wife would have. That means more money will be in there to accumulate and grow. Most attorneys don't understand this, so I'm going to repeat it, If you have a participant who dies before he/she starts receiving distributions, and the beneficiary is considerably younger than the participant, the beneficiary will not have to pay income tax on the whole amount, but instead, will be required to take distributions and pay income tax based on his/her actuarial life expectancy. So, we can have 35 or 40 years of a partial continuation of this tax-deferral party. Note that total distributions on his life would be over $800,000.

And for you true fans of dynastic economics, meaning people interested in literally creating a family financial dynasty, consider the third plan, naming a five-year-old grandchild the beneficiary of an IRA. That five-year-old will have an extremely long life expectancy, and the minimum distributions will be very small in the early years. In fact, the cumulative distributions using a 7% rate of return for that grandchild, assuming the grandchild takes out his minimum distributions, would be $3.3 million.

To confirm the logic of this, you can look to the Exhibit that shows the annual minimum distributions. As you would expect, the minimum distributions for a grandchild are minuscule and the distributions for the spouse accelerate quickly.

INHERITED IRA VS. OUTRIGHT GIFT

Let's compare the choice of leaving a five-year-old grandchild $100,000 in an IRA to leaving $100,000 in an account that is not tax deferred. Assume that the grandchild were to withdraw the same amount from both accounts at the same time over the years. The withdrawal amount would be the required minimum distribution from the IRA. However, the withdrawal amount for the grandchild, who has the outright inheritance, has to take out less money to have the same purchasing power because he does not have to pay income taxes on the portion he withdraws. Distributions, after adjusting for income taxes would be identical, but the grandchild with the outright gift would run out of money 14 years earlier than would the grandchild with the IRA. The grandchild with the IRA would receive an additional $1.5 million after income tax dollars over the next 14 years after distributions from the outright gift ended.

POST MORTEM PLANNING AND QUALIFIED RETIREMENT PLANS

Consider, for example, the possibility that your wealthy friend mentions that their parent just died leaving them a lot of money in a qualified retirement plan. You should immediately think--pay income taxes later, not now. Your demonstration of the power of tax deferral will potentially make an enormous difference. You would also be ahead of the vast majority of attorneys who do not understand these concepts. In addition, don't forget about the possibilities of disclaimers in estate administration.

BASIC EXPLANATION OF DISCLAIMERS

The issues of disclaimers is also fruit for a ten lecture series. Sufficient for our purposes to say that disclaimers should always be considered as an option in a substantial estate. I take disclaimers so seriously, that I include the possibility of disclaiming not only assets through the will but also assets in the plan benefits trust in my drafting. I prefer separate wills and plan benefits trust designations and often include disclaimer provisions in both documents.

A spouse can make a qualified disclaimer in effect saying " I don't want the property that was left to me." The next in line, either according to the will or the qualified plan beneficiary designation, will then receive the property as if that contingent or second beneficiary was named first beneficiary, even though the spouse survived. In that way, in may be advantageous in some circumstances for a spouse to disclaim to a younger beneficiary who would have a longer life expectancy and take out money at a slower rate.

Now the part you have all been waiting for: Why second-to-die policies make sense for people with substantial funds in IRAs or qualified benefit plans.

If you accept my premise that it is almost always better to keep money in the tax-deferred environment, and even upon retirement to spend down after-tax money first, there will be substantial growth in the estate. In addition, the remaining estate, even after the second death, will often be in the qualified retirement fund or IRA environment.

• That means potentially four taxes.

• Estate

• Income

• Excess Accumulation Tax

• Potentially, GSTT

Good planning will usually minimize GSTT tax and often excess accumulation tax. One word about excess accumulation tax--remember that after TEFRA, the spouse can elect to defer excess accumulation tax until his/her death. Also remember, if the spouse does pay excess accumulation tax, the funds remaining, if segregated, will forever be exempt from excess distributions tax and excess accumulations tax, even on his/her own death.

Generally, the largest problem will be the estate tax and the income tax.

As you can see from my analysis, I would prefer that if the heirs can afford it, that they postpone the income tax as long as possible. They can do this by keeping money in the tax-deferred environment. If, on the other hand, there is a substantial estate tax, and the only funds to pay the estate tax are money in qualified plans or IRAs, they will have to pay income tax on money to pay estate tax. So, if there is an estate tax of $500,000, they will have to take out $800,000 out of the IRA to pay the estate tax and if they take out $800,00 to pay the estate tax, that will trigger income taxes which will mean they have to take out more money from the tax-deferred environment to pay the income taxes that they took out of the tax-deferred environment to pay the estate taxes. We have seen diminution of 80% or more. This is where you get the phenomenal diminution of funds--there have been a series of scary articles regarding this topic.

The answer? Second-to-die or survivorship insurance that is owned by the children or an irrevocable life insurance trust.

Advantages:

• If ownership is not in either of the insured and the insured has no incidents of ownership, then the proceeds of the policy will not be in the insured's estate.

• Cheaper premium while both spouses are alive.

• Easier to get insurance if one spouse has a medical problem.

• If the client is wealthy (the only candidate for second-to-die policies), there should not be a need for significant cash on the first death because of the marital deduction.

• Lower economic benefit reportable for income taxes in split dollar plans by often as much as ten times lower.

• Administration costs should be kept to a minimum by hiring attorneys who will work on an hourly basis. The banks don't like this philosophy and neither do many of my fellow attorneys, but I think it is ethical and fair to perform estate administration on an hourly basis.

• You need the cash to pay estate taxes on the second death. In addition, you have all the traditional benefits of life insurance.

• This could be a savings of between 39% and over 50% if the proceeds of the policy are kept out of the estate.

THIS ISN'T A ZERO SUM GAME

The client wins. The insurance company wins. If the client can't understand how that works, say it would be a zero sum game if the IRS is included in the picture. Then, since the IRS is the big loser, the insurance company and the client can divide the IRSs share, hopefully the client gets more of the IRS share. Explained that way, people are much more likely to listen.

I explained about how keeping the proceeds of the policy out of the estate would save the family over 50% of the proceeds and it finally started to sink in that the insurance company could make money and his family could benefit too, and the only loser is the IRS.

Then, I told him the analysis wasn't over. You can keep money out of the estate but let us also compare the benefits of leveraging life insurance. Compare making gifts to the children and having the children invest the money. Assume the insured picks investments for the children that would do equally well as a life insurance investment. The reason why the second-to-die policy still makes the most sense is because of all the income taxes the children will pay on the income from the gifts.

In preparation for this talk, I ran some numbers comparing purchase of a second-to-die policy to making gifts to children. Let's assume that both insured would be 60-years-old and the premium would be $15,015 for 10 years and the death benefit is $1,000,000. Let's assume the second-to-die dies at 85.

The result is a 9.05% return on investment with no income or estate taxes.

Alternately, he gifts the same amount of money he paid in premiums to his children and they invest in 9.05% investment until the survivor of the insured reaches 85. The children will have less than $600,000. If they could find a tax-free investment at 9.05%, then they would break even with the life insurance policy, but who can find a guaranteed 9.05 after-tax investment.

In addition, many parents don't want to relinquish control, or they don't want their children to have the opportunity to spend the money. In addition, they may prefer having the money protected from creditors.

These numbers work. It is a better estate plan when you have a lot of money, particularly in the tax-deferred environment to utilize the second-to-die insurance policy. Some clients will want to have their children own the policy. Most would probably prefer the protection of an irrevocable life insurance trust.

If they go the way of the trust, they must take care not to retain any incidents of ownership. In addition, the trust must be drafted with extreme care. Finally, there will be notice requirements relating to the Crummey powers that will keep the gift to pay the premium nontaxable and not reduce the once-in-a-lifetime exclusion.

Finally, I will mention that I am available to draft these irrevocable life insurance policies. My concentration is with clients who have a substantial amount of money in the tax-deferred environment.

In addition, I draft wills, and special trusts as beneficiaries of the IRA or qualified benefit plan. In addition, we run numbers for clients with a program we developed internally that takes into account

• Appreciation

• Income taxes

• Excess distribution taxes

• Social security

• Inflation

• Spending patterns

James Lange, CPA, JD provides specialized retirement and estate planning services to married university faculty members with significant retirement plan accumulations.  He has prepared over 450 simple and complex retirement and estate plans.  These plans include tax-savvy advice, will and trust preparation, and sophisticated beneficiary designations for TIAA-CREF accounts, IRAs and other retirement plans.

You can contact Jim by phone at (800) 387-1129, or (412) 521-2732, or by e-mail at admin@faculty-advisor.com.