Spend The Money and Have It, Too

It's easy to forget that retired clients of relatively modest means can actually develop huge adverse tax consequences once they are forced to take minimum IRA distributions. But there are ways (albeit, somewhat complicated on first pass) to save your “middle-net-worth” clients thousands more in after-tax income right now, plus save their families many times that amount in estate taxes — all the while earning yourself a month's commission for every similarly-situated client you have. Really.

The Clients

They are a 65-year-old couple with two adult children. They have $500,000 in IRAs, $500,000 in real estate and $500,000 in cash (you have several of these in your book, whether you know it or not). The couple is collecting a total of $2,500 per month in Social Security checks. Their goals are to:

1. Maximize predictable income from their cash;

2. Minimize income taxes now and in the future;

3. Ensure a good portion of their estate is transferred tax-free.

The Problem

If you invest the cash in taxable fixed-income bonds, you might earn about 5 percent, or $25,000 per year. That amount should keep the clients in the 15 percent federal bracket for the time being, giving them at least $21,250 after Uncle Sam's bite. But soon the required minimum distributions (RMDs) from the IRAs may put them dangerously close to the 25 percent federal bracket. If the interest is taxed at that rate, there could be as little as $18,750 in net income, before state taxes.

You can avoid shoving your clients into the higher tax brackets by investing the cash in tax-free bonds, paying about 4 percent per year. Then the after-federal-tax dollars will equal $20,000 annually, regardless of their other income.

But whether you choose taxable or tax-free bonds, your clients may be subject to a lesser-known tax bite, especially once they begin taking the RMDs from their IRAs. As noted in the June 2005 issue of Registered Rep. (“Social Stupidity”), a couple can very easily have Social Security payments included in taxable income. The formula requires taxpayers to take half the amount of Social Security received, and then add adjusted gross income. If the resulting amount is over $32,000 annually for married couples, 50 percent of that year's Social Security payments are taxable. If the amount is over $44,000, 85 percent of the payments are taxed as income.

And to make matters worse, the IRS requires tax-free interest from municipal bonds to be included in the income calculation. Even more exasperating is the fact that the $32,000/$44,000 thresholds haven't been raised for inflation, even though they were established in 1983. (For more information, go to ssa.gov.)

The Solution (Step One)

Invest the $500,000 in a joint & survivor single premium immediate annuity. This will give the couple about $2,700 per month of income as long as they live. Because part of the payment is deemed to be a return of principal, only about $1,000 of the monthly payment will count as taxable income. Even in the 15 percent tax bracket, they will still net over $30,000 from the annuity after taxes in the first year.

But most importantly, the interest portion of the payments is only $12,000 per year, compared to $25,000 for the CDs and $20,000 for the tax-free bonds. So the immediate annuity payments are less likely to put the clients over the Social Security taxation threshold.

The Solution (Step Two)

Shrewd clients will quickly realize that although a single-premium immediate annuity will raise their after-tax income today, there will be nothing left over for heirs when the clients have both passed away. While a bequest worth “zilch” technically eliminates estate taxes, it's not the method your clients will cotton to.

Instead, solve the dilemma by transferring about $500 per month from their annuity payments to an irrevocable life insurance trust (ILIT). Assuming the couple is in good health, the trustee should be able to purchase about a $400,000 policy, the death benefits of which will go to the couple's children free of income and estate taxes.

Accomplishments

Admittedly, this is not as simple as sending an order ticket down to your firm's bond desk. But the fruits are well worth your labor:

1. Raise income today

   Even after the cost of the life insurance premiums are deducted, the couple will still have about $5,000 more in annual after-tax income than they would if they were to have used the fixed-income options. And the gap will likely grow even wider once the RMDs begin.

2. Cut income taxes now — and later

   The immediate annuity will generate little or nothing in federal taxes now. This will give the clients some wiggle room to begin making some small, hardly-taxed withdrawals from their IRAs. They can use the extra dollars to boost savings, or blithely spend it as they please. Plus, chipping away at the IRA now will reduce the RMD amount in the future.

3. Reduce estate taxes tomorrow

   Do you know what the heirs of the clients will pay in estate taxes when the couple dies? Do you know what their net worth will be? Do you even know what the estate tax laws will be when the clients pass away? Me, neither. But by establishing the ILIT containing the life insurance policy, you've made it more likely that at least some portion of the children's inheritance will not get hit by the dreaded “death tax.”

4. Develop a mutually-beneficial relationship with a CPA

   No doubt some of you got real sleepy when the subject of tax rates and the IRS came up. Fear not — you're not an accountant, and you can't give tax advice. But what you can do is offer to meet with your clients' tax preparer to see if the numbers make sense.

Eventually, you'll be able to separate every CPA into two categories: those who “get it,” and those who don't. The ones in the first group will gladly take referrals of clients currently working with the latter category, and should be happy to send several names of the tax-averse your way, as well. In the meantime, you can put together some rough figures on your own by checking out the financial calculators at dinkytown.net.

HIGHER INCOME AND LOWER TAXES NOW; NO TAXES FOR HEIRS LATER

Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future.
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