Reduce Your Retirement Plan's Tax Bite

Physician's Money Digest, September30 2003, Volume 10, Issue 18

Assets remaining in a retirementplan account upon the death ofthe account owner are potentiallysubject to income and estate taxes,which may leave the heirs an astonishinglysmall portion of the account—often as little as 30%.

However, there is a way to transferassets from profit sharing plans atreduced tax costs. The plan trustee canpurchase a life insurance contract on thelife of the account owner. A key elementin the potential tax savings is the valuationof the distributed life insurance policyat an amount less than the retirementaccount's assets used for its purchase.This valuation is a bit murky.

Basic Strategy

Physicians who are able to provide fortheir retirement income needs withafter-tax assets held outside of theirretirement plan accounts are potentiallyin a position to preserve their retirementaccounts for heirs. With a tax planningstrategy utilizing retirement accountassets to purchase life insurance, the substantialtax burden can be reduced. Theplan involves the following steps:

1. Assets in the profit sharing plan areutilized to purchase a life insurance policyon the life of the physician or, where theplan permits a second-to-die policy, on thephysician and spouse. The plan trustee isboth policy owner and beneficiary (ie, theultimate recipients of the death benefitare the designated beneficiaries).

2. After the plan acquires the policy, theplan trustee distributes the policy to theaccount owner. Alternatively, the accountowner or an irrevocable life insurance trust(ILIT) established by the account ownercould purchase the policy from the plan.

3. With a distribution, the accountowner then transfers the policy ownershipto an ILIT. The beneficiaries of thetrust can be the same as the beneficiariesof the retirement account.

Ways to Save

This planning approach can achievethe following major tax savings:

  • The retirement account assets thatare invested in a life insurance contract canultimately be distributed from the accountat a lower income tax cost than if distributedin cash or other investment vehicles.
  • Once the life insurance policy istransferred to an ILIT, in which theinsured holds no incidents of ownership,the death benefit can eventually go toheirs, without the income and estatetaxes to reduce net proceeds.

Of course, there are several tax consequencesto be mindful of, including thefollowing:

  • Annual income resulting from lifeinsurance protection
  • Income upon distribution of theinsurance contract from the plan
  • Gift tax upon transfer of the policyto an ILIT ownership

The utilization of a profit sharing planfor the purchase of insurance can be aneffective estate planning technique,with potential for reducing the dual taximpact that can devastate a shelteredretirement plan account balance uponthe owner's death. However, achievingthis through so-called springing cashvalue contracts can risk serious adverseconsequences. Consult with your financialplanner or tax advisor to see if thisstrategy makes sense for you.

Ori W. Pagovich, a vice presidentwith the Cowan Financial Groupin New York, handles the financialplanning affairs for the NewYork, New Jersey, and Connecticutchapters of the NationalAssociation of Residents and Interns and theAmerican Professional Practice Association. Hewelcomes questions or comments at 212-536-8754 or opagovich@finsvcs.com.