$16.6 trillion: According to the Investment Company Institute in Washington, that’s how much money Americans have stashed in qualified retirement plans as of the end of 2006. It’s a lot of money–and it’s never been taxed.

Many, if not most, Americans believe that their qualified retirement plan is a great tax shelter. And why shouldn’t they? They hear from every financial source that they should put as much money as possible in their qualified retirement plans. Everyone seems to agree that these tax shelters are “good” and should be used; the only argument is where to invest the money once it’s inside the plan.

But what happens at retirement? What happens when it’s time to withdraw money from these accounts? That’s when we discover that our qualified retirement plans are our highest taxed asset. No other asset, throughout our entire lives, is taxed at a higher level than our qualified retirement plan in retirement.

We only have to watch the 60 Minutes interview with David Walker, head of the Government Accountability Office (aired March 4, 2007) to learn that we live in a time where Washington’s lack of fiscal responsibility is coming to a head. That suggests tax rates will increase in the near future whether we want them to or not.

So let’s add this up: Trillions of dollars in retirement plans that have never been taxed plus massive fiscal irresponsibility in Washington leading to higher tax rates. It all equals a very ugly tax picture for retirees.

What is a retiree to do? To answer that question, let’s take a look at a typical retiree with $500,000 in his retirement accounts. We’ll make the following assumptions:

? Both husband and wife are 65 years old and in good health.

? The IRA is in the husband’s name (Joe) and the wife (Carol) is the primary beneficiary.

? Using TIAA-CREF’s 2003 mortality tables as a guide, we’ll assume that at least one of the spouses will live to age 90.

? Both husband and wife are conservative investors, so we’ll use a 6% rate of return.

? We’ll also assume a 25% tax rate.

Let’s look at this spreadsheet together (Figure 1) to see if this plan, which many people follow, makes sense.

Question: How much money does Joe withdraw in the early years, while tax rates are still at historic lows? Answer: $0 now and only from $25,000 to $30,000 during the first few years of distributions.

Q: How much money does Joe withdraw in the later years, after tax rates have increased? A: From $75,000 to $90,000. (Don’t forget the $1 million plus taxable balance to the heirs.)

Q: Does it make any sense to withdraw small amounts when tax rates are low and large amounts when tax rates are high? A: Obviously not.

Q: What should Joe do? A: Start taking out money right now while tax rates are lower!

Now that Joe is retired, he needs to deal with this tax monster called a qualified plan. His goal should be to reposition his now “tax-hostile” qualified funds to a more “tax-friendly” (ideally tax-free) environment. This can happen all at once or over time.

Tax-free or tax-deferred growth

If Joe wants to move to “tax-free” vehicle (and who doesn’t?), then he should consider either of two destinations for his retirement dollars: a Roth IRA or a maximum-funded life insurance policy. Both destinations offer the following advantages, assuming that the life insurance is properly designed:

? Tax-free distributions (using withdrawal to basis or loans with the insurance);

? Income tax-free death benefit to heirs;

? No impact on level of Social Security income taxation when funds are withdrawn;

? No required minimum distributions, thereby allowing the couple the freedom to use or reinvest the money.

The life insurance may offer an additional advantage: Many of today’s insurance plans include a long term care rider that may either be free or have a nominal charge.

When Joe transitions his account to either the Roth IRA or a maximum-funded life insurance contract over 10 years, he needs to move roughly $67,900 each year. At a 25% tax rate, he pays $16,975 of tax, leaving $50,925 to reposition.

He can either convert the after-tax amount of $50,925 into a Roth IRA or pay the $50,925 into a 10-pay life insurance policy. His minimum death benefit would approximate $698,000. This process is then repeated each year over the next 10 years (assuming tax rates do not increase during that time). If rates increase, appropriate adjustments can be made.

Using this approach, the maximum-funded life insurance provides the best result, often by hundreds of thousands of dollars. If you add in the fact that certain life insurance carriers include free LTC riders on their policies, you end up with a terrific solution for your client.

Additionally, should the client request that beneficiaries receive their account as a “Stretch IRA,” the life insurance death benefit can be paid into a trust that provides the same benefit, yielding a significantly better tax result, assuming the funds within the trust are invested in a tax-efficient manner.

Finally, consider the total number of taxable distributions from Joe’s qualified retirement plan should he choose to transition to a more tax-friendly environment. He distributes $67,900 for 10 years until the qualified retirement plan is exhausted. That totals $679,000 that he pays tax on. Compare that to Figure 1 and you will see that he and his wife, Carol, pay tax on roughly $1.1 million, leaving an additional $1 million taxable for their heirs.

By moving to a tax-friendly position, Joe is able to pay tax on $679,000 vs. $2.1 million. This represents a significant tax savings for him and his family!