Watch Out for Retirement Plan Tax Traps

Christopher R. Jarvis, MBA

Physician's Money Digest, November30 2003, Volume 10, Issue 22

Most financial professionalsadvise contributing as muchas you can to qualifiedretirement plans. Conventionalwisdom maintains that these plansmake good tax sense because they receivea deduction and achieve tax-deferredgrowth. Unfortunately for many highlycompensated professionals, includingphysicians, this conventional wisdom isdangerously wrong. In fact, retirementplans are a tax trap for these investors.

High-Income Drawbacks

A misconception among workingpeople today is that when they retire,they'll be in a lower tax bracket. Withthe amount of invested assets inside andoutside retirement plans and long-termgrowth of the securities markets, manyAmericans will maintain their currenttax bracket after retirement. For manytaxpayers, the value of the tax deductionand deferral are not as great asconventional wisdom espouses.

For example, Frank is a 50-year-oldorthopedic surgeon with $1.5 million inhis profit sharing plan. By the time heretires, the plan's funds will grow to atleast $3 million. If Frank withdrawsonly the interest from the plan after heretires (not considering any principal orother sources of income), he and hiswife will still be in the top tax bracketfor the rest of their lives. Taxpayers likeFrank have no tax arbitrage.

Wall Street Journal

These taxpayers simply get the deductionand 1 tax rate, and then pay thetax at the same rate. In fact, the planmay actually cause reverse arbitrage,since distributions will be taxed as ordinaryincome (likely 38.6%) and gainsoutside of the plan will be subject to thecapital gains rate, capped at 20%. AnApril 15, 1999, columnconcludes that for many taxpayers,qualified retirement plans are a"fool's game."

Leftover Asset Traps

What happens to assets in a retirementplan when they are not used? Themajority of these funds end up withstate and federal tax agencies. Did youthink that after paying taxes for a lifetimeyour tax-qualified plan would betaxed at rates between 70% and 90%?Let's look at how these taxes are leviedand what you can do about it.

Income in respect of a decedent(IRD) is income that would have beentaxable to the decedent (ie, the deceasedperson) had they lived long enough toreceive it. IRD recipients must reportincome received in gross income and payresulting income taxes the year in whichthe items are received (typically, the yearof death). The IRD is an income tax thatis assessed in addition to federal andstate estate/inheritance taxes.

Because federal and state incometaxes (including those characterized asIRD) can reach 45% in many states andestate tax is assessed between 37% and60%, you can see how quickly the combinedtax rate escalates. Although thereis a partial income tax credit for estatetaxes paid, the total tax on IRD assetscan be more than 90% in some cases.

What types of assets qualify for IRDtreatment? Income earned by a decedentbut not yet paid (eg, bonuses andcommissions) qualifies as IRD. Onceincome is paid to the estate, it will behit with income taxes and estate taxesunder the IRD rules. Retirement plans,such as pensions, 401(k)s, and IRAs(to the extent that contributions wereoriginally tax-deductible), are the mostimportant assets hit by IRD taxes.

Savings Possibilities

Jim is a single physician who has afully taxable IRA. His other assetsexceed the current estate tax exemption.Assuming his $1-million estate isheld in the IRA, Jim's estate (or heirs)would pay $500,000 in estate taxes onhis death and then another $279,000in state and federal income taxes (ie,45% of the remaining amount aftergiving a deduction for federal estatetaxes paid). Therefore, only about$220,000 is left for Jim's beneficiaries.Over 77% of Jim's funds were takenby the IRD tax system.

Now, let's assume Jim liquidated hisIRA, paid the income taxes, and diedthe next day. In this case, Jim paid theincome taxes on the $1-milliion liquidationhimself and his estate paid theestate taxes the next day. While thesetransactions were only 1 day apart,Jim's heirs were better off in the endbecause there was no IRD. The taxquirk: Federal tax rules do not allow anincome tax credit for state estate taxespaid, only for federal taxes paid. WhileJim's heirs benefited by only an extra$54,000 because of early liquidation,there are other available strategies thatcan save more.

Smart Investor Shuffle

In many cases, it may make sensenot to use qualified retirement plans,especially if you can predict that youwill not need those funds during retirement.If after a financial analysis youdetermine that retirement plan proceedswill end up as part of an estateplan, consider ending participation inthe plan as soon as possible. Of course,you will need to carefully analyze assetprotection issues before you make afinal decision.

What if you have built up a largeplan balance but won't need most or allof the funds for retirement? Unless youwant 70% or more of the funds goingto state and federal taxes, you musttake action. This may involve usingadvanced estate planning techniques,which often require a rollover, the creationof a special-purpose qualifiedretirement plan, and a combination oflegal and financial provisions.

The bottomline:

While the details of such techniquesare beyond the scope of this article, thethreat of significant IRD can be eliminatedfrom your estate plan if you planproperly. Figuring your way throughretirement plan dilemmas requiresexpertise in financial planning andforecasting, estate planning, and taxlaws. It is crucial that you consult witha professional who has experiencedealing with retirement plans and preservingplan assets from the ravages ofincome and estate taxes. Talk to an expert before you makean estate planning move.

Christopher R. Jarvis has createdbooks and tapes on taxes, asset protection,and estate planning forphysicians, including The Doctor'sWealth Protection Guide, and hasaddressed numerous medical societiesthroughout the country. His firm, Jarvis &Mandell, LLC, services clients on a nationwidebasis. He welcomes questions or comments at 888-317-9895, or visit www.jarvisandmandell.com.