A qualified plan is a terrific asset accumulation tool and adopting one is a good idea for successful business owners who want to save on current taxes and grow money for their retirement. Many business owners find that after establishing a qualified plan they are so enamored with watching their money grow without paying current income taxes that their qualified money is the last money they want to use when they finally get to retirement.
But this is where too much of a good thing can suddenly turn into terrible news. Qualified assets–either in a qualified plan or an IRA–can be reduced by as much as 80% by income and estate taxes at death. And that is very bad news.
Sad ending, happy ending
Consider Pat and Chris, a husband and wife team with a successful consulting business. They have personal assets with a net value of more than $3 million and establish a conventional defined benefit plan to save on current income taxes. In 10 years they will be happy to have accumulated another $2.1 million in the defined benefit plan, increasing their net worth to more than $5 million. When they stop working, they roll the qualified plan money into IRAs, where the funds continue to grow.
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Pat and Chris like the tax-deferred growth in their IRAs and don’t want to pay more current income taxes than they need to, so they draw on other assets for income. They plan to leave the IRA assets to grow until they are forced to take required minimum distributions and plan to pass on whatever remains at death to their children.
Here’s the sad part of the story: The $2 million IRA they were planning to pass on to their children could end up being $800,000 or less.
There can be a happier ending with some smart planning. Life insurance is an ideal tool to replace potentially heavily taxed funds with a tax-free death benefit. Paying for the life insurance with pre-tax dollars can be even better.
If we add life insurance to Pat and Chris’ defined benefit plan, we can provide an immediate death benefit. Should Pat or Chris die, the pure death benefit (or face amount) will pass income tax-free to their beneficiaries. The full premium for the insurance is tax-deductible as part of the qualified plan contribution. (See chart 1.)
Adding $3.4 million of life insurance coverage to their plan increases their deductible plan contribution by only $55,771, though the total premiums for the life insurance are $97,219. Taking into account that the $55,771 is tax-deductible as a plan contribution, at a 34% tax rate the net after-tax cost for adding the insurance is only $36,809. (See chart 2.)
To purchase the same coverage outside the plan, Pat and Chris would have needed earnings of $147,301 to net enough to pay the $97,219 premium after taxes (assuming a 34% tax rate).