Is Your Retirement Plan a Tax Trap?

Keego Harbor, MI -- (ReleaseWire) -- 02/13/2007 --David B. Mandell, JD, MBA and Keith L. Mohn, CLU, CHFC (www.benefitsolutionsgroup.biz) are nationally known financial planners who focus on the special asset management needs of physicians. For over a decade, they have worked with thousands of doctors to help them reduce taxes and have more money available for retirement. The two advisors like to ask their clients if they plan on leaving any dollars in their pension, 401(k) or IRA to children or grandchildren? “Most of my clients,” says Keith Mohn, “are surprised to learn that in spite of sophisticated money management tools, the vast majority in such funds end up with state and federal tax agencies -- not with the physician’s family.” Imagine! Would you believe that after paying taxes for a lifetime of work – your “tax qualified” plan could be taxed at rates between 70-90%? On hearing this, Keith Mohn’s clients are shocked, appalled and want to know what they can do about it. Before a solution is recommended, Mohn believes it is important for everyone to understand how these taxes are levied. “The first step in better asset management,” says Mohn, “is to learn what an “IRD” is.”

The Basics of IRD
IRD means “income in respect of a decedent” (a deceased person). This is income which would have been taxable to the decedent physician, had he or she lived long enough to receive it. Now that the physician is dead, whoever receives these items of IRD must report them as gross income and pay any income taxes in the year the items are actually received – typically, the year of the death, in addition to any federal estate (death) taxes and state estate/inheritance taxes.

As federal taxes can reach nearly 40% (even without a state income tax), and estate tax is assessed between 37% and 50% (assume 50% here), one can see how quickly the combined tax rate escalates. Although the rules provide for a partial income tax credit for estate taxes paid, the total tax on assets characterized as IRD assets can be over 90% in some cases.

What types of assets qualify for the dreaded IRD treatment? Income earned by a decedent but not yet paid, like bonuses or commissions, qualify as IRD. Once they are paid to the estate, they are hit with income taxes and estate taxes under IRD rules. The most important IRD asset? Retirement plan--like pensions, 401(k)s, and IRAs (to the extent contributions were originally tax deductible).

How IRD Eats Up a Retirement Plan
Take this example of Jim, a single physician, whose other assets exceed the current estate tax exemption. He received what he thought was good asset management counsel, but his IRA is fully taxable – as it was funded entirely with tax-deductible contributions. (The same illustration could be made for a married couple, but the estate tax wouldn’t be due until the second spouse dies if he/she were the beneficiary, due to the unlimited marital deduction).

Assuming Jim’s fully taxable estate of $1,000,000 is held in the IRA, Jim’s estate (or heirs) would first pay $500,000 in estate taxes upon Jim’s death and then pay another $248,000+ in federal income taxes (i.e., 40% of the remaining amount after giving a deduction for federal estate taxes paid). Thus, only $250,000 or so is left from the IRA for Jim’s beneficiaries – about 25%!

The bottom line is, Jim’s IRD IRA is taxed up to 75%!!

Some advanced asset management options to consider…

#1. Better--Same retirement plan, but Jim liquidates it himself!
With the same retirement plan as described above, if Jim liquidated his IRA today, fewer taxes would be due. In this scenario, assume Jim paid the income taxes on the $1,000,000 liquidation himself and his estate paid the estate taxes the next day. While these transactions were only one day apart, his heirs would better off. Why? Because there was no IRD…no “income in respect of a decedent,” because no one had died yet! This quirk exists because the federal tax rules do not allow an income tax credit for state estate taxes paid, only for federal taxes paid.

In illustration #1 the heirs benefit by receiving only an extra $48,000 thanks to early liquidation. But wait…there are even better strategies than liquidation. And these can potentially save 70% or more of the IRD taxes.

#2. Best.

How To Avoid The Tax Trap
If you have already built up a large plan balance – and now realize that you don’t need most or all of the funds in retirement--there is a way to avoid the tax trap for your heirs. Mr. Mohn repeats for emphasis, “If you don’t want 70% or more of these funds to go to state and federal taxes, you must do something beyond traditional money management … and the earlier the better.” This can involve the use of advanced estate planning techniques, often requiring a rollover--creation of a special purpose qualified plan -- and a combination of legal and financial disciplines. While the details of such techniques are beyond the scope of one article, Mohn says with advanced planning, the threat of significant IRD can be eliminated from a physician’s estate plan.

For a 40% discount on Jarvis & Mandell’s new book, Wealth Protection M.D., or for an audio CD on Asset Protection please call (800) 554-7233 or email info@wealthprotectionalliance.com.

David B. Mandell, JD, MBA is an attorney, lecturer, and author of Wealth Protection, MD. He is also a co-founder of The Wealth Protection Alliance (WPA) – a nationwide network of elite independent financial advisory firms whose goal is to help clients build and preserve their wealth with advanced asset management tools and compensation strategies.

Keith L. Mohn, CLU, CHFC is a financial consultant and lecturer,and President of Benefits Solutions Group, LLC, in Keego Harbor, Michigan, a full service financial consulting and planning firm specializing in money management strategies for high net worth individuals, business owners and physicians. Mr. Mohn has been providing advanced compensation strategies and asset management counsel for medical professionals since 1983 and is a member of The Wealth Protection Alliance. Mr. Mohn can be reached at 248-681-9320.