Leveraging The QPIP To Avoid The 70% Tax Trap
By Warren S. Hersch
Individual retirement accounts have long been touted as vehicles to protect savings from taxation on ordinary income. But affluent boomers edging into retirement still must grapple with how to insulate the IRA (or pension plan) from the potentially devastating ravages of the estate tax. One option to weigh: the qualified plan insurance partnership.
“A QPIP lets clients use money in a qualified plan or IRA to buy life insurance in a tax-favorable manner, where the ultimate beneficiary is an irrevocable life insurance trust,” says Roccy DeFrancesco Jr., a wealth preservation planner with the Wealth Preservation Institute, New Buffalo, Mich. “The result is that policy death benefits pass to heirs free of both income and estate taxes.”
Thats a desirable outcome, but couldnt it be achieved by other means? DeFrancesco says no, observing that other popular tax-advantaged vehicles either incur estate tax penalties or sidestep the tax by cutting the heirs inheritance.
Consider an IRA or pension plan holding $1 million in assets. Federal estate tax would shave $500,000 from the total. Federal income tax, factoring in the estate tax paid, would cut another $200,000. That leaves just $300,000 net to heirsnot including state taxes.
“This 70% tax trap, which concerns income in respect to a decedent, or IRD, is the worst kind of money in a clients estate because its money that ultimately will be double taxed by the IRS,” says DeFrancesco. “Most clients dont know about the problem. Theyre operating out of ignorance.”
Solutions that advisors typically propose to avoid the double taxation all have problems, he adds. Among them: the so-called “stretch IRA.”
The technique extends the duration of traditional and Roth IRA distributions to certain successor beneficiaries, beyond the death of an original designated beneficiary. The stretch thus delays income taxes due on an IRAs distribution by using a clients child as the “measuring life.”
The catch is the stretch does not forestall estate taxes. Revisiting the above example, the child would still pay $500,000 in death taxes on the IRA, says DeFrancesco. Unless the child buys life insurance to cover the estate taxes, he or she likely would have to withdraw additional funds from the IRA to cover the tax.