By Dennis Drake
Qualified Tax Avoidance Planning, known as Q-TAP, helps investors minimize taxes as they remove assets from qualified retirement plans. Normally, withdrawals from qualified plans trigger large tax bills. This strategy uses the existing tax code and guidelines to reposition assets to pay the least amount of tax legally possible.
Consider this illustration: For the past 30 years, Julie has enjoyed a thriving career as a physician. She is now age 53 and has $1 million in her qualified plan and $750,000 in traditional investments outside of a tax-qualified/tax-deferred account. She's been dutifully maxing out her retirement contributions every year while also building the nest egg of traditional investments. Now retirement is just around the corner. As much as she's looking forward to enjoying freedom from work, there's a question on Julie's mind: How much of her savings will be left to support her in retirement, and how much will she leave her two sons when she dies?
After a bit of research, Julie realizes that the biggest challenge to her comfortable retirement is Uncle Sam. Up to half of her retirement account could be lost to taxation, and her kids could be left with only 25 cents on the dollar for any money that she doesn't spend. The conventional ways to get at her retirement money are limited to five unpleasant options:
Convert the entire balance of the account into a Roth IRA and pay the tax upfront (37% federal tax + state tax + estate tax if applicable)
Spend the money as needed, paying the taxes over time (We are very likely to have future tax increases, so this also creates an unknown risk.)
Take out only the minimum required distributions to limit taxes, but expose the remaining balance to double taxation.
Stretch out the taxation for the benefit of her children, with complicated, long-term beneficiary planning.
Avoid the taxes altogether by leaving her retirement plan to charity, which is not so great for her kids.
Julie's investments outside of her retirement account aren't safe, either. They're subject to dividend and capital gains taxes any time Julie wants to use the money. Whichever way she turns, Julie will lose money to the IRS.
Q-TAP planning is an approach that could help protect retirement funds from income taxes and fluctuating markets. Simultaneously, it can free assets outside of qualified retirement plans from capital gains and dividend taxes. It hinges on transferring taxable assets (including qualified plans and outside savings) into a tax-free environment where they can continue to grow and be readily accessible.
Step 1: Moving Money from Taxable to Tax-Free Environments
In Julie's case, we want to start by changing the investments inside her qualified plan. Right now, her $1 million qualified plan is invested in stocks and bonds. Using Q-TAP, her plan will use that money to buy a cash value life insurance policy instead.
Why life insurance? Because it's the only asset that can be removed from a qualified retirement plan tax-free. Usually, Julie would have to pay taxes when removing money from her qualified retirement plan. When she takes it out in the form of a life insurance policy though, that's an exception. Q-TAP planning can work with any qualified plan as long as the client can be characterized as a business owner.
The premiums for Julie's life insurance policy cost $1 million. She pays these premiums using the pre-tax dollars inside her retirement plan. Now, the life insurance policy is inside Julie's qualified plan.
Next, she can buy that policy from her qualified plan for 75 cents on the dollar. By paying $750,000 from her non-qualified accounts into her qualified plan, Julie removes a taxable $1 million in the form of the life insurance policy. The policy can now grow tax-free in her hands. This helps Julie because the cost of owning the life insurance policy is much less than the taxes and management fees she would have paid on her previous investments. That's aside from the fact that the $1 million of life insurance premiums funds a $5 million death benefit, a great protection for Julie's family. This strategy will work with as little as $500,000 with no limit on the high side.
Julie started out with $1 million in her qualified plan and $750,000 in cash and outside investments. She now has the life insurance policy in her hands (removed tax-free from her qualified plan) and $750,000 in her qualified plan. Plus, she's gained a $5 million tax-free death benefit for her kids.
Step 2: Profiting from a Roth Conversion
When Julie removed her life insurance policy from her retirement plan, she had to reimburse her plan at a rate of 75 cents on the dollar. That meant moving $750,000 from her nest egg into her qualified plan. Now her $1 million is safe, but that $750,000 in her qualified plan is still exposed to high taxes. How can she protect this investment as well? That's where part two of Q-TAP comes in.
At this point, Julie will convert her qualified plan into a Roth. Even though she must pay a tax on the Roth conversion, she still wins in the long run. Any future growth on that money and all withdrawals will be free from income or capital gains taxes. Once her $750,000 is growing tax-free, it will come out far ahead of the same amount subject to taxes.
The tax on the conversion is about $300,000. But this is the only tax that Julie will have to pay to move her $1.75 million from the taxable to the tax-free world.
Even better, Julie won't have to pay the tax on the Roth conversion out of her own pocket because she now has the perfect asset to cover it - her new life insurance policy.
Step 3: Leveraging the Cash Value of Insurance Policies
We now turn to the question of how Julie will get the money to cover the Roth conversion tax. Fortunately, there's no need for her to pay out of her own pocket. She'll use her new life insurance policy to cover the cost.
Think about it this way: Every permanent life insurance policy has both cash value and a tax-free death benefit. Julie can borrow against her life insurance policy, and the $300,000 will be paid out of her death benefit when she dies. As an added benefit, her policy's cash value/death benefit can also cover the interest on the policy loan.
Additionally, whatever money in the Roth IRA that Julie doesn't use for her own retirement can be passed down to her kids and grandkids as an inherited Roth, leaving a legacy of tax-free income for decades beyond her death.
In this case, we've learned that Julie's $1.75 million dollars in savings isn't all hers. She will lose around 40% or more of both her qualified plan and her nest egg to taxes during her lifetime. And, after she dies, anything left will be double-taxed (income and estate taxed) before being passed on to her heirs.
Julie wanted to take action to protect her hard-earned savings, but she wasn't sure how. The wrong move at the wrong time could trigger a hefty tax bill, and she wasn't even sure what kind of changes she should make to her investment options. As her $1.75 million grew, so did her tax exposure. To top it off, the tax rules could change at any time, triggering compliance costs, regulations, and even more taxes.
We verified this plan would work for Julie by stress-testing them under a multitude of potential situations. Here's what we found: Keeping the same beginning balances of $1 million in qualified funds and $750,000 in non-qualified funds, tax rates, and growth assumptions, Q-TAP makes a huge difference. By the time Julie is 95, Q-TAP will deliver an additional $2.8 million in tax-free cash and income. And, if she doesn't spend the money and leaves it all to her kids, they stand to inherit over $11 million more than under her current plan.
There are 40 million baby boomers in the U.S., with 10,000 retiring daily. By 2030, 20% of the U.S. population will be retirees. As a result, by the early 2030s, the Social Security trust fund is predicted to run out of money. And don't forget, the current U.S. debt is over $20 trillion. Since the only revenue source for the government is taxes, and the average income tax rate for top earners in the U.S. between 1913 and 2013 was over 55%, don't you think taxes have to go up in the future? We certainly do.
With Q-TAP, you pay only one tax on two pots of money. You also pay the tax now, while rates are low. And, you don't pay the tax out of pocket.