Use liquidate and leverage to mitigate the 75 percent tax trap

By Roccy Defrancesco

The Wealth Preservation Institute

As I've talked about in past articles, the 75 percent tax trap is the double tax that is levied upon a client's tax- deferred IRA or qualified plan assets at death (assuming the client has an estate tax at the time of death).

As you know, when you die with income-tax-deferred assets, the IRS wants to be paid the income taxes that are due on the entire deferred balance. Also, when you die with an estate tax problem, the IRS wants its estate taxes that are due.

Let's look at a single client who has an estate tax problem and $1,000,000 in his IRA. Only $250,000 of the $1 million IRA balance will pass to the heirs after the double tax.

IRA Account Balance at Death$1,000,000
Estate Tax($500,000)
Income Taxes (State and Federal)*($250,000)
Total Taxes($750,000)
Total IRA Asset After Tax$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.

The above numbers are depressing, and something of which most clients with the double tax problem are unaware.

Use liquidate and leverage to mitigate the problem

What is L&L? It's a fancy term for taking systematic annual distributions from an IRA or qualified plan where the money left after paying income taxes will be used to buy life insurance in an ILIT.

Why use L&L?

It will pass more wealth to the client's heirs versus the "do nothing" scenario. If a client does nothing, money in the IRA/qualified plan will grow; and when the client dies, the entire balance will be taxed with both income and estate taxes.

Yes, you could use a stretch IRA; but the estate tax is still due, and the children will liquidate the IRA and pay the estate tax due. When that happens, income taxes and a penalty will be due on the withdrawals, which is a guaranteed loser.

When calculating L&L, advisors need to put in several needed variables (income-tax bracket, estate-tax bracket, rate of return, RMDs, premium for life insurance, death benefit, etc.). Using these variables will tell you how much more wealth will pass to the client's heirs by using L&L vs. doing nothing.

L&L example

Let's look at a 70-year-old man in good health who has a five million dollar estate and $1,000,000 in an IRA he doesn't need to live on. I assumed the money in the IRA grows at 6 percent, a guaranteed DB of $1,376,000 from the life policy purchased in the ILIT, that he is in the 40 percent combined federal and state income tax bracket, and that he dies after 2010 under the current law.

To Heirs AfterIRA After Tax
Income & Estate TaxPlus DB Improvement with% Improvement
AgeWhen doing NOTHING!With L&L Liquidate & LeverageLiquidate & Leverage
70$266,810$1,624,333 $1,357,523509%
75$367,255$1,614,374 $1,247,119340%
80$501,673$1,601,047 $1,099,374219%
85$681,555$1,583,212 $901,657132%
90$922,278$1,559,345 $637,06869%
95$1,244,419$1,527,406 $282,98723%
100$1,657,516$1,484,664 ($190,852)-11%
Which one will the above client like better? L&L is 509 percent better than doing nothing in year one, 132 percent better at the age the client is supposed to die (age 85), and better until age 100.

What if the client was married? If the client was married to a 70-year-old, a second-to-die policy could be purchased in the ILIT and the guaranteed death benefit would be $2,390,000. L&L then becomes 889 percent better than doing nothing in year one, 281 percent better at the age the client is supposed to die (age 85), and 49 percent better at age 100.

Should you be talking with your affluent clients about the 75 percent tax trap? Absolutely.

Should you be explaining to them the simplicity of L&L and how it can significantly increase the amount of wealth that can be passed to their heirs? Absolutely.

To try my new L&L calculator, contact me using the forum below.

*For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.