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Maximizing Your Qualified Retirement Plan

by David Van Meter, M.S.Acc., Ph.D.

Many of our clients have planned very carefully and worked very hard to fund their retirement savings in order to enjoy a comfortable and worry-free retirement. They have put as much money as possible into their 401(k) plans and traditional IRAs, as well as other qualified savings vehicles such as SEPs or SIMPLEs.

But because successful saving is a lifelong habit born of thrift, many of our most successful retirement savers face a unique challenge in retirement: they do not need to draw cash from these assets in order to fund their lifestyle, and yet the statutory obligation to begin Required Minimum Distributions at age seventy and a half causes them to increase their taxable incomes and thus pay higher taxes, and interferes with their desire to leave these assets to their heirs.

Here we would like to mention two ideas that may help some of our clients maximize their retirement savings. Of course, these are fairly advanced strategies and they do not apply to many people, so be sure to call us to see if they may be right for you.

Funding Life Insurance with Qualified Plans

Generally speaking, traditional qualified plans are not terribly efficient vehicles for transferring wealth to heirs. This is because these plans accumulated tax-deferred assets, and the taxes are due upon the distribution of those assets, whether to you or to your heirs. Who wants to inherit a large tax bill?

One possible solution is to use taxable distributions from qualified retirement accounts like 401(k)s and IRAs to fund a life insurance policy in order to potentially increase the amount that is transferred to heirs. Life insurance is an efficient asset to transfer to heirs because the proceeds are not normally subject to ordinary income taxes when paid to the beneficiary at death. If you are concerned about estate taxes, then you can explore the possibility of owning the insurance policy in an Irrevocable Life Insurance Trust (ILIT). Using your after-tax RMD to fund life insurance can potentially provide substantial leverage and increase the amount left to your heirs.

Roth Conversions

One of the most annoying features of taking a RMD when you don't need the funds is that it can increase your income tax burden. We all understand that we need to pay taxes on the RMDs themselves, but for some clients the extra income from a RMD can cause some of their Social Security to be taxed as well.

The unique way that Social Security is taxed changes the marginal tax on retirement income. At low incomes, Social Security benefits are tax-free, but as your income increases, up to 85% of Social Security benefits can become taxable. In short, every dollar of retirement income above a certain level can turn into an increase of $1.85 in taxable income! A person in the 25% tax bracket can wind up paying an effective marginal rate of 46.25% on retirement distributions.

In some situations, where retirement plan distributions themselves trigger a substantial increase in the amount of Social Security being taxed, it may make sense to consider a ROTH conversion. While this strategy results in a large tax bill in the year of conversion, it can potentially save you considerable sums of money in future years by preventing some or even all of your Social Security from being taxable. Again, this strategy is not right for everyone, but for some of our clients it may be a means of minimizing the amount of your wealth that you give to the government in the form of income taxes

Van Meter and Van Meter, LLC.
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