A key financial objective of clients should be to find the most cost-effective and tax-efficient way to pay for expenses, from education to retirement, and to transfer assets to heirs.  Planning is not just about tax savings; it must be economically and financially beneficial, too.

For years, I have told our firm’s advisors, “The next person who comes to me saying that their client wants to save estate taxes will get a one-page (one-sentence) design:

“Given everything you own to charity when you die!”

The objective is not to save taxes.  It is really these two:

  • The estate: “Maximize what I can leave my heirs.”

  • Retirement: “Maximize my retirement income.”

Have you ever met a client who simply asked for ways to save current income taxes?  Of course you have.  But, how would they react to recommendations like:

  • Pay your employees higher salaries.

  • Increase benefits you provide your employees.

  • Pay higher an interest rate on your debt.

  • Pay higher legal, accounting, and financial planning fees.

All of these recommendations save taxes.  Do any of them provide a benefit to the business owner? 

Instead, tell the client, “If there’s a 401(k), that means that there’s also a 401(a, b, c, d, e, etc.)”  Review their current retirement plans.  There’s more to qualified plans than a 401(k).  When we do qualified plan analyses, we are looking to see how much can be allocated to the owners versus what they would net from simply paying taxes on their profits.

This above chart is an example of a “floor offset” defined benefit plan placed on top of an existing 401(k) plan.  The client had sufficient income to benefit from a $229,525 deduction. 

Eighty-five percent of the contribution was allocated to the owner, Mr. Brown.  If he was in a 40 percent combined federal and state income tax bracket, and he had not set aside these dollars into this plan, he would have netted $137,715.  Instead, $195,095 is working for him (tax deferred, more about that later).

So his choice is this:

Give more to the government

$91,810

or

$0.00

Give more to my employees

$0.00

or

$34,430

Keep more for myself

$137,715

or

$195,095

How do you think he would rank the choices? I believe that the government needs the money.  I just want it funded by other people’s clients, not mine.

You should also review client’s non-deductible (after-tax) spending.  What is the most tax-efficient and cost effective way to pay for their children’s (and grandchildren’s) education, from private pre-school through graduate degrees? 

The key is finding lower tax bracket family members.  I have found more tax savings in a family tree than on a tax return.  Many of our clients have K-1 income reported on Form 1040, Schedule E, and/or other “business” income reported on their Form 1040, Schedule C.

With today’s high lifetime gift exemptions ($5.34M in 2014), you can gift income-producing assets (e.g., S-Corp stock, LLC member interests, etc.) to a trust designed to “spray” income to spouse, parents, children, siblings, etc.

So, how should I pay my daughter’s $60,000 school expenses?  In a 40 percent combined federal and state income tax bracket, I would need $100,000 to net $60,000.  But, my mother may need to receive only $80,000 to net the same $60,000 in her 25 percent combined federal and state income tax bracket.  My older daughter (after the kiddie tax age) may need to earn only $75,000 in her 20 percent combined federal and state income tax bracket.

Remember, direct gifts for education can exceed the annual gift exclusion ($14,000 in 2014). And even without that, they each have their own lifetime gift exemption ($5.34M in 2014).

That is much more tax-efficient that putting my mother or my daughter on the company payroll and paying FICA, FUTA, etc. After the education expenses are paid, the trustee can spray the income to my spouse.

For the business owner, you can also create a lower tax bracket enterprise (e.g., SLOB, separate line of business).  You establish a legitimate business reason to have a C-Corp. 

Let me make this point perfectly clear: I am not suggesting that you change your operating business from S to C.  Many of our business owner clients operate their business as an S-Corp, own their business real estate in an LLC, and have established a C-Corp as a sales or marketing arm, for example.

C-Corporations have their own tax bracket, and they are not subject to the 3.8 percent added tax (currently, 2014).

Single

 

 

C-Corp

 

 

From

To

Rate

From

To

Rate

$0

$9,075

10%

$0

$50,000

15%

$9,075

$36,900

15%

$50,000

$75,000

25%

$36,900

$89,350

25%

$75,000

$100,000

34%

$89,350

$186,350

28%

$100,000

$335,000

39%

$186,350

$405,100

33%

$335,000

$10,000,000

34%

$405,100

$406,750

35%

$10,000,000

$15,000,000

35%

$406,750

 

39.6%

$15,000,000

$18,333,333

38%

     

$18,333,333

 

35%

Let’s return to that first comment about leaving everything to charity at death.  What’s the best asset to give to charity at death?  Low basis, appreciated assets, right?  No!  That’s a good idea during lifetime.  But, at death, the best asset to leave to charity is your retirement accounts. 

But, where do you find the provision for making a charitable bequest?  The answer is in the client’s will.  That results in assets that would pass to children with a step-up in cost basis going to charity.  Assets that incur ordinary income taxes pass to children.  Does that make any sense? 

So how do you save taxes for clients’ heirs?  A more tax-efficient and cost-effective use of retirement accounts would be to establish a separate IRA with charities or a charitable trust as beneficiary. 

Do not comingle people with charities.  Otherwise all of the funds in the retirement account have to be distributed within 5 years of death.  Heirs lose the ability to spread out their income taxes (“stretch”).

We have a client whose will provided for a $250,000 gift to a local hospital that specializes in cancer treatment.  The couple had more than $1,000,000 in qualified plan assets.  They agreed to establish a separate IRA with a charitable trust as beneficiary (so that they could change charities, if they wanted).  They explained that that $250,000 IRA would be the last money they would ever touch, taking required minimum distributions (RMD) for this amount from the balance of their IRAs. 

We suggested funding this IRA with a variable annuity that had a 5 percent guaranteed income benefit rider.  The $12,500 of income (5 percent of $250,000) came to them subject to income taxes (they were over age 59½ so no early withdrawal penalty).  They offset the $12,500 of income with a charitable deduction of $12,500 to their charitable trust. 

The charitable trust then purchased a $1,000,000 survivorship (second-to-die) life insurance policy.  Now, they plan to donate $1,250,000 instead of the original $250,000 at no additional cost to them.  How’s that for tax-efficient and cost effective?

Now, let’s return to our defined benefit pension plan.  After 10-years of funding nearly $200,000/year, Mr. Brown has over $2,000,000 at retirement.  If he only needs to take required minimum distributions (RMD) to meet his retirement income needs, then he will likely still have $2,000,000 in those accounts at his death. 

Instead of having his heirs pay income taxes as they make withdrawals, consider using life insurance to fund the income taxes on a Roth conversion in his year of death, or by his surviving spouse. (Note:  spousal IRA rollovers can convert to a Roth, but inherited IRAs cannot, under current law). 

So, his tax-deferred account has its taxes paid with pennies on the dollar using the leverage of life insurance.  Here we have, again, a tax-efficient and cost-effective solution.