ELITE ADVISOR BEST PRACTICES

Redirecting Trillions of Dollars of IRD Taxes to Trusts for Retirement, Family and Charity

Advanced IRD solutions can generate current income tax deductions. They can also allow funds to grow tax-free, provide tax-efficient income during retirement or transfer money tax-free to heirs.

By Tim Voorhees

Key Takeaways:

  • The Income in Respect of Decedent (“IRD”) tax affects far more clients than were affected by the estate tax.
  • A wide variety of assets—including retirement plans, pensions, profit sharing plans, stock options, deferred compensation programs and annuities—can be subject to high IRD taxes.
  • Planners can provide great value by helping clients minimize or eliminate IRD taxes.
  • IRD planning solutions must be squarely within the letter and spirit of the tax code.
  • As a rule of thumb, clients should see tax savings of at least ten times the cost of designing, drafting and funding trusts to reduce IRD taxes. Often the IRD planning benefits are more than 100 times greater than the costs.


American advisors have been preoccupied with helping clients reduce income, estate, gift and capital gains taxes; however, surprisingly little has been done to lower expected taxes on more than $20 trillion of assets that generate income in respect of decedent (“IRD”). IRD assets are those that accumulate tax-free while the client is alive but incur substantial income taxes at the client’s death. Current and prospective clients are often alarmed when they learn how taxes on IRD assets can dramatically lower the inheritance available for heirs.

Currently, much of the $20 trillion of American IRD assets could be subject to estate taxes of 40 percent and IRD taxes of more than 50 percent. IRD assets subject to the high potential taxes include:

  • IRA plans
  • 401(k) plans
  • 403(b) plans
  • Pensions and profit sharing plans
  • Nonqualified stock options
  • Incentive stock options
  • Deferred annuities
  • Unpaid salaries, fees, commissions or bonuses
  • Deferred compensation plan benefits
  • Accrued (unpaid) interest, dividends and rent

While state and federal treasury departments would like to tax away IRD assets, Americans can work with astute planners to “disinherit” the government tax collectors. Through wise use of planning tools, it is possible to redirect tax money to trusts for generating tax-free retirement income, tax-free transfers to family members and tax-efficient gifts to favorite charities.

Before selecting and customizing the best IRD planning solutions, it is important to understand the magnitude of the problem. A calculator such as the one at MVMLawyers.com/CalcIRD helps determine whether the expected taxes will be high enough to justify transaction costs related to implementing solutions. Because basic IRD trusts may cost $3,000 or more to design and draft, clients need to see at least $30,000 in tax savings to justify paying for IRD planning. In fact, clients with $500,000 of IRD assets may see tax savings that are 100 times greater than the costs to implement IRD solutions. Clients with larger retirement plans or annuities, even if using more expensive and sophisticated trusts, may see tax savings that are several hundred times greater than design and drafting costs.

Common problems that result from cutting corners on IRD planning

Example 1: Clients may be tempted to save money on planning fees by using traditional planning tools to lower IRD taxes. For example, a common noncharitable technique involves withdrawing money from a retirement plan, paying income taxes on the withdrawal, gifting the after-tax money to an insurance trust, funding an insurance policy that grows tax-free and taking tax-free wash loans or death benefits from the policy. This solution works, but it subjects the taxpayer to large income taxes that erode the assets available to invest in the strategy.

Example 2: Clients may also try to zero out some IRD assets by using charitable trusts. For example, a testamentary lead trust can eliminate estate taxes, but it will still leave IRD assets subject to income taxes. A testamentary remainder trust can reduce both income and estate taxes, but income streams will be subject to taxes at ordinary income rates.

Available strategies provide much better after-tax returns

Advanced IRD solutions can generate current income tax deductions. They can also allow funds to grow tax-free and provide tax-free income during retirement as well as tax-free transfers to heirs. Such advanced techniques rely on creative combinations of executive benefit plans, charitable trusts, low-interest loans, high-cash-value insurance policies and/or transfers to irrevocable trusts. The integration of the techniques requires close cooperation between the drafting lawyers and the professionals designing the insurance policies. While the integrated solutions may appear complicated, astute planners can summarize them on a simple flowchart that is accompanied by cash flow projections and annual administration checklists. In this way, the client’s accountant or lawyer can usually administer the IRD planning with relative ease.

The best IRD planning solutions, even involving multiple planning tools, should be squarely within the letter and spirit of the tax code. It is wise to involve both the client’s CPA and lawyer in reviewing the plans so that clients can have confidence that solutions can achieve projected benefits over time while withstanding any audits that may arise.

Conclusion

The Elite Advisor Forum may have a critical mass of advisors who want advanced training on the best IRD tax planning solutions. Advisors should feel free to click www.VFOS.com/survey/Training to indicate the types of training and resources that would be most helpful. As survey results are tabulated, our editors will suggest next steps for advisors who believe that $20 trillion in IRD assets should perpetuate the legacies of the people who earned the money.


About the Author

Tim Voorhees, JD, MBA, is an estate planning lawyer and investment advisor based in Irvine, California. He is the president of the Registered Investment Advisory firm described at Voorhees Family Office Services.com and the managing partner of the tax law firm described at www.MVMLawyers.com Feel free to email Tim at tim@vfos.com.

Readers of this document should consult with independent advisors regarding the tax, accounting and legal implications of the proposed strategies before any strategy is implemented. Nothing in this presentation is intended to offer securities or investment advice. Tax and regulatory rules affecting strategies in this document may change often and have varying interpretations. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or for promoting, marketing or recommending to another party any matters addressed herein.