Converting an IRA from a Tax Loser to a Tax Winner

We are all basically dealt the same cards in the tax game, but how we play them determines whether the IRS wins or we do. Sadly, most taxpayers play their IRA cards wrong, and the result is that their families lose. 

Almost all IRAs are “traditional” IRAs whereby the account holder receives a tax deduction for the funds he or she puts into them, and income taxes on profits and other gains are deferred until the funds are taken out of the account. All other qualified plans (401(k), profit-sharing and the like) can be rolled over into a traditional IRA.

As the owner of a traditional IRA, you must take required minimum distributions (RMDs) from your account every year, starting when you reach age 70½. These distributions are based on life expectancy tables, so the percentage of the account required to be withdrawn increases a bit each year. Because RMDs decrease as life expectancy increases—in other words, the younger the beneficiary, the lower the RMD—it is to your advantage to make someone younger than you the beneficiary of your IRA. Often, this person could be your spouse. But what if you make your children the beneficiaries of your IRA? Now the life expectancy tables make this minimum distribution amount so small that almost all of the IRA funds can grow—tax deferred—for another full generation. Make that for two generations if you leave all or some of your IRA to your grandchildren. Great tax planning! This is called a “stretch” IRA. (Do not make your estate or a trust the beneficiary of your IRA, as this eliminates the stretch-IRA option.) 

Commonly, IRA holders do make their spouses the primary beneficiary and, in case the spouse dies first, will make their children and/or grandchildren contingent beneficiaries. As the beneficiary:

1. The spouse can roll the IRA funds into his or her own IRA, pushing the RMD down the road to when he or she reaches age 70½ (assuming that the spouse is younger than the deceased).

2. The spouse can name new beneficiaries, most likely children or grandchildren.

3. The spouse may be able to convert the traditional IRA to a Roth IRA, which provides a huge tax advantage to the family’s younger generations. This conversion can take place all at once or over several years, if this option can help reduce income taxes. (There are key differences between traditional and Roth IRAs that any qualified tax advisor should be able to explain.)

The enemy of the traditional IRA is a possible double tax. There are always income taxes (both federal and state), and if the account holder’s overall estate is large enough, the estate-tax monster will get its bite as well. The average double-tax rate is a whopping 64 percent—$64,000 out of every $100,000 in the estate to the tax collector and only $36,000 to the family.

The typical reader of this column who calls me for tax help is a male owner or retired owner of a closely held business whose age may range from his late 40s to early 80s. Rarely does this person need the funds in his IRA to maintain his current lifestyle. What started out as a good idea early in his life—parking deductible contributions in a qualified plan—has turned into a lousy, tax-prone asset later in life.

What to do? The goal is simple: Turn the funds that are subject to double-tax in the investor’s IRA (or other qualified plans) into tax-fee dollars. This is easy to do if this person is insurable (and, if he is married, if his spouse is insurable as well). We typically use our trusty “Retirement Plan Rescue” (RPR). It’s a simple, four-step process:

Step 1. Purchase an annuity for the IRA. If the IRA already owns an annuity, this existing policy can be used in the following steps.

Step 2. Annuitize the annuity, converting it to a flow of guaranteed income into the IRA every year for as long as the investor or the spouse lives, depending on whether it is a single-life or second-to-die annuity.

Step 3. The IRA distributes an annuity amount annually, which is subject to income taxes. This distribution is often all or part of the RMD.

Step 4. Use this annuity distribution to pay the premiums on a new life insurance policy. This could be a single-life policy if the investor is not married or a second-to-die policy if he or she is.

The sooner the IRA owner implements this strategy the better, as premium costs rise each year and health issues that he encounters as he ages might lock him out of certain policies. 

In addition, insurance proceeds are income tax free, according to the Internal Revenue Code, and setting up an irrevocable life insurance trust will help avoid estate taxes as well.