IRA-pension rescue, Pt. 1 -- Using cash-value life insuranceArticle added by Roccy DeFrancesco on July 30, 2009
Roccy Defrancesco

Roccy DeFrancesco


Joined: May 24, 2006

It's been about a year since I touched on the topic of the 75 percent tax-trap and what some in the industry call Pension-IRA Rescue. Besides that, with all the talk about the Obama tax increases, pension rescue is more important than ever.

Also from a selfish standpoint, I know that insurance and financial planners love this topic because the commissions from life insurance sales are huge (and that does not affect the benefit to clients which is nice).

What is the 75 percent tax trap?

To sum it up briefly, the 75 percent tax trap, often called the double-tax trap, arises when clients with estate tax problems also have money "trapped" in IRAs and/or qualified plans.

The classic client is 60+ years old who has an estate of $5,000,000 or more and $500,000+ in an IRA or qualified plan that they do not need to use for retirement income. The key is that the client doesn't need the tax-deferred money for retirement. If that is the case, you can nearly guarantee that such clients will have that money double taxed at their death.

Let's look at an example:

Dr. Smith has a $5,000,000 estate, a $1,000,000 IRA and lives in a state with a 5 percent income tax. Assume Dr. Smith dies after his spouse and with an estate tax problem. What taxes will be due on the IRA?

Estate Tax:($500,000)
Income Taxes (State and Federal)*($250,000)
*The exact calculation of the income tax due in the above example is quite complicated and the $250,000 number used is an approximation.

Pension rescue: a brief history

Pension rescue is a simple concept. You have the client use money in a profit sharing plan that is going to get double taxed and you use it to buy a 5-pay life insurance policy inside the plan. At the end of the fifth year of owning the policy inside the plan, the cash surrender value (CSV) of the policy would be approximately 20 percent of the premiums paid. Then, the policy would be sold to an irrevocable life insurance trust (ILIT) and the client received effectively an 80 percent discount when removing the money from the plan.

The IRS basically killed pension rescue when new valuation rules on the value of a policy transferred from a qualified plan were introduced. These proposed regulations changed the discount on a policy removed from a qualified plan from 80 percent discount to approximately 10 percent to 20 percent.

As sometimes happens in the insurance industry, smart people figure out how to work within the new regulations and now pension rescue is back and can, once again, be very beneficial for our clients. Having said that, I'll deal with the new pension rescue in Part II of this newsletter next week (to read next week's newsletter please click here).

Liquidate and leverage (L&L)

"Pension rescue" can come and go as laws change, but L&L will always work for your clients and should be discussed with EVERY client that has the 75 percent tax dilemma. L&L is a very simple concept. You simply start systematically liquidating IRA assets or money from a qualified plan and gift the money after taxes, to an ILIT. The ILIT will purchase a life insurance policy with the largest possible death benefit (DB). The DB will be used to pay for the double tax due on the IRA balance at death and will pass additional wealth to heirs income and estate tax free.

It's really that simple. Let's look at an example:

Assume a client has a sizable estate, which means the client has an estate tax problem. Assume the client has $500,000 in an IRA that is not needed for retirement income and that the client is in the 40 percent income tax bracket. How can L&L be used to mitigate the 75 percent tax dilemma?

The client will take systematic withdrawals of $31,500 from his IRA every year and gift that money to an ILIT, which would use the money to purchase a life policy with an initial DB of $559,000 (which increases to $2,081,000 at age 100). You'll notice I assumed this client lives in California and has the 80 percent tax trap due to a nearly 10 percent state income tax.

IRA Start of YearYear EndTo HeirsDeath BenefitIRA After Tax
AgeBalanceBalanceAfter 80% TaxL&LPlus DB

Now let's compare the do-nothing scenario (remember in the above chart I assumed the client removed $31,500 a year from the IRA to be used to pay life insurance premiums). The left hand column below assumes the client does nothing and the right hand column is the improvement with L&L).

To Heirs After 80%IRA After TaxImprovement with
AgeIncome & Estate TaxPlus DBLiquidate & Leverage

How did the heirs fare with the L&L? $551,156 better at age 60, $886,297 at age 80, and more than a million dollars better at age 90.

*Note: These numbers would apply at the second spouse's death due to the fact that the IRA balance can transfer to the spouse without taxes at the first spouse's death. The chart also does not take into account the Required Minimum Distribution (RMD) that will start to come out at age 70 ½.

To say that L&L is better than doing nothing would be an understatement and is why all advisors need to learn this topic.

As our population ages, more and more clients will be faced with the 75 percent tax trap of money in a qualified plan or IRA. Doing nothing should not be an option for our clients. At the very least, we should be counseling our clients about the simple but powerful L&L concept.

Check back in for my next article, which will explain how traditional IRA/Pension Rescue works under the new guidance.

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