Saving Your Qualified Retirement Plan

Military team working together

In Saving Private Ryan, Tom Hanks played an army captain for a band of men whose mission was to find Private Ryan and escort him safely home (because his 3 brothers had already lost their lives in World War II). Though your qualified retirement plan is not a matter of life and death, it may help to have a clear strategy and a team of people on your side to save it from heavy losses to the IRS.  If the goal is preserving a legacy for the generations to come, sometimes drastic action needs to be taken.

Why your Qualified Retirement Plan May Need Saving

You may have received a qualified retirement plan as part of a compensation or profit-sharing package. Qualified retirement plans can come in 2 forms, both funded with pre-tax dollars. Defined Contribution, such as a 401(k), is where participants can choose their contribution levels/investments, and their total retirement savings amount varies as a result. Defined Benefit, such as a pension, is where the participants receive a set monthly retirement benefit, based on preset defined criteria (such as length of service).  In either case, when it comes time to access the money, Uncle Sam will be tapping into your savings right along with you. This is why:

  • Penalties: If you want to withdraw the funds before retirement age (59 ½), you will pay an early withdrawal penalty of 10% right off the bat.
  • Income Taxes: Because money was invested with pre-tax dollars, withdrawals are taxable as regular income in the year that is is withdrawn, up to 37%.
  • Estate Taxes: Any unused portion of your qualified retirement plan dollars will become part of your estate, and thus become subject to estate taxes (40% for any amount over the prevailing exemption limit; currently $11 million per individual, but in 8 years will likely be closer to $5 or $6 million per individual).  We discuss estate taxes in more detail here.

Let’s be conservative and use an example where Pritash (now single) faithfully invested in his 401(k) for the 15 years that he worked for a large multinational. Over the years, he accumulated $4 million in a tax-deferred retirement plan. As it turns out, his other investments and savings have carried him through his retirement, and he leaves the plan to his daughter. However, due to the size of the estate, she loses 40% to estate taxes. Let’s say she is able to claim an income tax deduction due to all the estate taxes paid, so she only loses an additional 10% to income taxes.  In the end, she receives $2 million from the account; unbeknownst to Pritash, fully half of the assets have been lost. This is one qualified retirement plan that really needed saving.

A Way Out

If you don’t want to trigger income taxes and/or penalties by simply pulling out of your qualified retirement plan, what can you do?  Take advantage of some legal ways around the taxes:

  1. Use the retirement plan dollars to buy an insurance policy.  You will be using pre-tax dollars to buy life insurance, which is by nature not taxable! Because it is pre-tax, you will be able to use more money to pay for life insurance than if you bought a policy outside of your retirement plan.  (Note: the economic benefit of using pre-tax dollars to purchase the policy is taxable.)
  2. Now, most people don’t know that you can pull a life insurance policy out of a qualified retirement plan without triggering taxes as long as you sell it to the plan participant, or a trust, at fair market value. So you can now buy your own life insurance policy, effectively pulling funds out of your retirement plan and shielding it from taxes.
  3. Reposition the funds that remain within the plan into a Roth IRA, which will trigger taxes now, but allow for tax-free withdrawals later.  You can get a tax-free loan from the life insurance policy in order to pay the taxes if they are significant.
  4. Pat yourself on the back – you have just taken a tax-riddled account and transitioned it to two tax-free vehicles; a Roth and a life insurance policy, resulting in guaranteed more wealth passed down to the next generations!

Just So You Know:

The Qualified Leverage Strategy may not be for everyone. Here are a few things to keep in mind:

  • The qualified retirement plan must have at least $1 million in assets, and the owner must also have at least an additional $1 million in assets outside of the plan.
  • In a Defined Contribution plan, you cannot pay more than 50% (for a whole life policy) of your plan contributions to fund premiums for the life insurance policy (unless the money has spent more than 5 years in the plan).  That limit is 25% for universal life insurance policies.
  • In a defined benefit plan, the death benefit cannot exceed 100 times the monthly expected retirement benefit.

The Qualified Leverage Strategy must be carefully mapped out for each individual case.  But once you have saved your qualified retirement plan from tax erosion, you and your beneficiaries will feel that you accomplished a very worthwhile mission.

If you would like Axia Global to help you determine whether the Qualified Leverage Strategy will work for you or your affluent clients, please give us a call.  We are here to help; it is our goal is to make a measurable difference in your financial life.

Note: the statements above should not be considered financial, legal or tax advice, but ideas for careful consideration with your trusted financial advisors and lawyers. For current tax or legal advice, please consult with an accountant or an attorney.