Mitigating the 75% Tax Trap Part II

Mitigating the 75% Tax Trap Part II

On Recording: Click here to view/listen to an educational webinar

            In Part I of this series I explained the 75% Tax Trap that millions of people have with money in their IRAs and/or qualified plans.  Additionally, I explained one simple solution called Liquidate and Leverage (L&L) which will pass significantly more money to the heirs at a client’s death than doing nothing. To read Part I one of this series, please click here.

                        The “New” Pension Rescue

           In Part II, I will discuss the “new” version of “old school” pension rescue.   In order to understand this material you first need to understand “old school” pension rescue.

            What is pension rescue?

            Pension rescue is when a client buys a 5-pay life insurance policy inside a qualified retirement plan to soak up the majority of the money in the plan where after purchase; the policy is sold to an ILIT at a discount (thereby saving the client on both income and estate taxes due on the money at death and where a large death benefit is purchased using a life insurance policy owned by an ILIT.

            For a full explanation of “pension rescue” with an example, please click here to read a simple one page summary.

            The IRS killed “old school” pension rescue

            As many advisors know, the IRS killed “old school” pension rescue with Rev. Proc. 2004-16;  and Rev. Ruling 2004-20; and 2004-21.  Why did these kill pension rescue? Because the new value of a CVL insurance policy for roll out or purchase by an ILIT would be nearly the same amount as the premiums paid (and therefore, there is virtually no tax savings to the transaction). 

            As is the case many times with the IRS’s guidance, it made little sense to those in the industry. Having said that, the IRS accomplished its goal of throwing cold water on that pension rescue technique and most in the industry stopped using it back in 2004 (2004-21 put it on the listed tax transaction list which really helped advisors stay away from it). 

                        Pension Rescue is back (with a SAFE HARBOR valuation)

            The first thing that helped bring pension rescue back is Rev.  Proc. 2005-25. (Click here to read about 2005-25).   The IRS offered a new “safe harbor" that included a new Average Surrender Factor(ASF) for the valuation of life insurance policies that were to be either distributed from or purchased from a qualified retirement plan. The ASF is basically a factor used in a formula to derive the FMV of a policy. The factor is typically between 70-100% (depending on the policy year).

            How is the ASF applied to come up with this new safe harbor value?  To make things simple, take the cash account value (CAV) of a life insurance policy upon sale or distributions from a qualified plan and multiply that by the ASF.

            If you are not following me, let’s look at an example.

            If you have $1,000,000 in a qualified plan and you use pension rescue, you would pay premiums of $200,000 a year for five years to soak up the money into the policy.  At the end of the 5^th year, you would value the policy as it is distributed to the plan participant or sold to an ILIT.

            If the CAV is $800,000 you would multiply that by the ASF (which should be approximately 70% in year five if you are using a properly designed policy).

            $800,000 x 70% = $560,000  

            And there you have it; pension rescue with decent discounting is back.  It’s not like the old days with an 80% discount or a value of $200,000 for purchase by an ILIT, but it’s not bad.

            How do clients normally solve the 75% Tax Trap?  They don’t.  Most do nothing or painfully pay premiums after tax to an ILIT to buy a large death benefit.

            What were the real savings to this client? 

            The profit sharing plan now has 

$560,000 in it instead of $1,000,000. Therefore, the client avoided the 75% tax on $440,000 dollars which would have been double taxed had it been left in the plan.  In 2011 and beyond this would save his heirs $242,000 (or more depending on what President Obama does with his massive tax increases).

            And the client moved from the “do nothing” position most clients are stuck on and ended up being proactive to mitigate the 75% Tax Trap while at the same time moving a life insurance policy to an ILIT which will significantly increase the after-tax estate passed to the heirs.

          What about IRAs?

            If you have clients with sizable account balances in IRAs and estate tax problems, never fear, you can help them.  These types of clients should have at least one Family Limited Partnership (FLP) for asset protection and estate planning reasons.  If they don’t have one, you can help them create one.  Once an FLP is created, the client will become an employee/manager of the FLP. Once an employee, a new profit sharing plan can be created inside the FLP and the IRA money can then be rolled into the newly created plan where the client can then take advantage of the “new” pension rescue.

                        Summary on the “new” pension rescue

            The 75% Tax Trap of money in a qualified plan or IRA is one of the most difficult issues to deal with in a client’s estate plan.  Doing nothing SHOULD NOT be an option for your clients as the maximum amount of money will be paid to the IRS upon a client’s death. As your read in Part I, Liquidate and Leverage is much better than doing nothing.  While L&L is simple, it is not as powerful as the “new” pension rescue technique which can now be done properly with guidance from the IRS.

           If you want to move into the affluent client market, this is a terrific topic to use as a door opener.  You can be nearly guaranteed that the client’s current advisors are not discussing how to mitigate the 75% Tax Trap and once you bring this topic to the table, you’ll be seen as a real problem solver in the client’s eyes.  Additionally, if you make money selling insurance, you’ll love this topic as the commissions are usually quite large (and are not a detriment to the transaction).