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Here’s Part Two of our discussion on qualified retirement plan pros and cons.
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These Weird Tricks Bail Clients Out of Qualified Plan Traps

Two weeks ago, we talked about the pros and cons of traditional qualified plans. Savings go in tax-deferred, cutting the saver’s current tax bill and hopefully, according to the architects of the system, helping them save more for retirements that get longer and more expensive with each passing year. Savings accumulate tax-free for the saver’s working career. Finally, at retirement, those savings come back out, to be taxed at ordinary income rates.

That works great if your tax rate today, when you’re deducting the money going in, is higher than it is tomorrow when you’re taking it out. It also works great if your contribution today comes with an employer match. In that case, it doesn’t much matter what the tax rate coming out tomorrow is. It’s free money for retirement. Kind of like what happens if we discover Bigfoot is real. Who cares if his fur is black, or brown, or gray? It’s Bigfoot!

But what happens if your tax rate tomorrow is as high as it is today? Or worse, higher? We’ve just loaded about $7 trillion in fresh Covid relief debt on the country’s credit card, on top of Washington’s usual sea of annual red ink. Interest rates are low now, but they won’t stay that way forever. You don’t have to be a card-carrying economist to know that tax rates are likelier to head up than down in the future.

Traditional IRAs and qualified plans distort investment decisions in other ways, too. For starters, everything coming out is taxed as ordinary income, even if the source of the income is capital gains or qualified corporate dividends. There’s no chance to profit from lower rates on those types of income, or stepped-up basis at death. Required minimum distributions kick in at age 72, under current law, and even if that age rises to 75 as some have proposed, they still force taxable distributions in plenty of cases where your clients wouldn’t make that choice for themselves.

Finally, traditional tax-deferred savings force clients to lock up their money until age 59½ or later. Yes, there may be escape hatches: plan loans, 72(t) withdrawals, or expensive premature distributions with an extra 10% penalty. But the regular restrictions force hard choices on clients who might also eye those savings for college tuition, vacation homes, or similar big-ticket expenses.

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The calculation is different for business owners, too. Business owners aren’t on the receiving end of those matching contributions that make qualified plan contributions such a great deal for employees. Business owners pay those costs, along with the costs of administering the plans. Those costs can easily eat up the value of the up-front tax deferral with no corresponding benefit on the back end.

So, what’s the alternative when plain vanilla retirement planning doesn’t work? Here are four alternatives that don’t risk leaving you with a bigger tax bill coming out than when you went in. Think of them as “French vanilla,” or perhaps “Vanilla Bean” for your clients’ savings.

1. Plain Old Taxable Accounts

Taxable accounts strip away all of the advantages of contributing to tax-deferred accounts, but also avoid all the disadvantages of those vehicles: the penalties for early withdrawal, RMDs, and especially the disadvantageous tax treatment of long-term capital gains and qualified corporate dividends. Clients can sock money into growth stocks like Amazon, Facebook, and Google that currently pay no dividends and get the same tax-deferred growth they would enjoy in an IRA. But then when it’s time to cash in the gains, they’ll profit from significantly lower tax rates. There’s no penalty for pivoting to alternate uses like college or a beach house. They can even borrow against their stocks, in the form of a deductible margin loan, without disturbing that tax-deferred growth. The main challenge with using taxable accounts for retirement planning is to invest efficiently to avoid tax bites during the accumulation phase.

2. Roth Accounts

For clients who don’t mind shoehorning their savings into a slightly less restrictive set of rules than traditional retirement savings, Roth IRAs and 401(k)s (along with their backdoor cousins, the Roth SEP and “Sparkle Pony” 401(k), aka Mega Backdoor Roth IRA), offer tax-free income down the road. Roth 401(k)s may be ideal for business owners looking to sponsor retirement benefits for employees – they can hitchhike on the back of a plan that wouldn’t benefit them if they were limited to traditional front-loaded contributions.

3. Insurance Insurance/Annuities

Life insurance offers clients who can benefit from the death benefit coverage an attractive opportunity to create tax-free income in the form of loans and withdrawals. Today’s contracts offer far more investment options than in the days of stodgy whole life and poorly-designed universal life choices. Clients can “bank on themselves” for any purpose they like, including college tuition, cars, and even emergency funds.

Nonqualified deferred annuities offer clients tax-deferred growth (though no advantages putting money in or taking it out. They also do a better job anchoring a portfolio against market volatility for those who choose annuities for the fixed-income portion of their asset allocation. (Remember, bonds and bond funds fluctuate in value according to interest rates – which are a lot likelier to go up in the near term than further down – and annuity contracts guarantee no loss of principal value.) This can actually let clients invest the equity portion of their portfolio more aggressively than they might otherwise.

4. Charitable Vehicles

Charitable remainder trusts offer an underappreciate opportunity to invest for retirement under a tax-advantaged umbrella. Clients can establish a Net Income Makeup Charitable Remainder Unitrust (NIMCRUT) today, make partially-deductible discretionary contributions over time, invest those contributions for capital growth, keep any capital gains they realize inside the trust, then “flip the switch” into income-oriented options to draw income for retirement. At death, of course, the remaining funds go to charity – but it’s easy enough to use life insurance to replace them for heirs. Pooled Income funds offer a similar opportunity with an even bigger deduction for every dollar contributed, although with less flexibility because the income starts immediately and there’s no control over the fund portfolio.

Clients hear the terms “IRA,” “401(k),” and “403(b)” so often that we can forgive them for thinking those are the only alternatives they have to eating cat food in their golden years. But conventional wisdom here can be quite hazardous. It’s up to you to help guide your clients through the forest of options. That’s a more complicated job than it appears at first. But it’s also a route to profitable and fulfilling long-term relationships. The more you know here, the more valuable you’ll be, whether you offer the financial products and services or not!

Edward Lyon

Edward Lyon

Edward A. Lyon is CEO of the Tax Master Network, where he's coached tax professionals to add planning and financial services to their business since 2005. Go here to join the network. Go here to upgrade your membership or discuss opportunities in financial services.
Edward Lyon

Edward Lyon

Edward A. Lyon is CEO of the Tax Master Network, where he's coached tax professionals to add planning and financial services to their business since 2005. Go here to join the network. Go here to upgrade your membership or discuss opportunities in financial services.

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Previous Issues of Tax Tactics

Tricks and Traps with Qualified Plans

Qualified plans can be the best way for clients to save tens of thousands in taxes every year — except when they wind up costing even more in taxes they don’t have to pay!

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