IRA Rescue Using Home Equity Management
By: Roccy DeFrancesco, JD, CWPP™, CAPP™, CMP™
As I’m doing a series of newsletters on what’s right and wrong with the Equity Harvesting concept (Missed Fortune 101), I couldn’t overlook this particular issue.
IRA planning is hot right now as our public gets older and as more and more money is transferred into IRAs when clients retire.
Those selling the Equity Harvesting concept (removing equity from a home and repositioning it into cash value life insurance for tax-favorable retirement income) have also been partially educated on this topic through books and seminars. I say partially because, as usual, the books and selling seminars do not give full disclosure on this issue and make the use of Equity Harvesting sound much more useful than it actually is.
IF your clients have an estate-tax problem when they die (and as you know, most of the American pubic does not have an estate-tax problem), the money in their IRA or qualified retirement plan could be taxed in excess of 70%. Due to space issues, I will not give a full explanation of this issue. Instead I’ll give you the approximate math so you can see it for yourself.
Dr. Smith has a $5,000,000 estate, a $1,000,000 IRA and lives in a state with a 5% income tax. Assume Dr. Smith dies after his spouse and with an estate tax problem. What taxes will be due on the IRA?
Estate Tax: ($500,000)
Income Taxes (State and Federal)* ($250,000)
Total Taxes ($750,000)
TOTAL IRA ASSET AFTER TAX $250,000
*The exact calculation of the income tax due in the above example is quite complicated and the $250,000 number used is an approximation.
What is IRA rescue? It’s when clients like Dr. Smith, who have estate-tax problems and income-tax deferred money in IRAs or qualified plans that they don’t need to live on, use techniques to mitigate the double tax.
When clients find out that 70-80% (depending on the state income tax) will go to the government when the last spouse dies, they usually get upset and start looking for answers. There are not many good answers out there. I deal with a few in the CWPP course and I’ll be doing a newsletter on a unique tool in a few weeks, but for this newsletter, I want to focus on how to use home Equity Management to mitigate this problem.
The pitch by Missed Fortune type advisors is to convert tax hostile money (IRA money) to non-hostile money (money in cash value life insurance). It’s interesting to note that they may even advise a client to remove money from tax deferred accounts before age 59.5 even though the client will incur not only the income taxes, but a 10% penalty as well.
Is it sound advice to convert? I wish I had the space in this newsletter to break down the math on this issue. I’ll just say this, remember that clients considering converting assets from an IRA to a cash value life insurance policy are usually 59.5 years of age or older. Because of the client’s age, the cost of a life insurance policy (even one run at the MEC minimum) will not be insignificant and because of the commissions paid to the life insurance agents, the cash available to the client in the short-term for retirement income will be significantly reduced.
Creating Mortgage Deductions
This concept is very simple. If clients can create a deductible home mortgage payment, they can remove money from an IRA to pay for the mortgage without paying taxes on the money removed from the IRA.
Why? Because every taxable dollar removed from the IRA will be allocated to a deductible home mortgage interest expense (IF setup correctly).
The following example is very specific. It deals with a couple who wants to sell their home. If the client simply wanted to re-finance the home, the interest might be deductible up to the first $100,000 of debt or not at all.
Example: Assume your client Dr. Smith and his spouse are now retired. They are both age 60 and have $400,000 in one or more IRAs. If the clients sold their current $600,000 home (which has $100,000 of debt on it) and buy a new smaller (downsized) condo for $500,000 with a home loan of $420,000 at 6.5% (interest only), the mortgage payment each year on the new condo will be$27,300.
If the client removes $27,300 from IRAs to pay this mortgage payment, there will be no taxes due on the withdrawn money because the clients can deduct the $27,300 of IRA income on their tax returns due to the interest expense.
If the $400,000 in the IRA(s) grows annually at 5.5% (net), the clients will be able to remove $27,300 of IRA income every year until at age 86. Therefore, the client can remove all $400,000 (plus investment returns during the payout phase) from the IRA(s) and pay NO income taxes.
That’s great right? You just showed a client how to remove money from an IRA and pay no income taxes.
Things to think about.
Where did the client invest or reposition the money from the sale of the home?
If the money were to be invested in stocks and mutual funds, the client would have to deal with dividend taxes, capital gains taxes, mutual fund expenses and money management fees (if a professional money manager is involved). Additionally, if such investments are chosen, the client has 100% risk of loss (so if another 9-11 market crash happens, the client is in really big trouble).
If the money were invested into annuities, all the growth would be income taxed when withdrawn.
What about life insurance. That’s the reason financial planners and insurance advisors flock to the Missed Fortune approach. Sure, the money could go into a cash building life insurance policy. The problem is that the client is over the age of 60 so health is an issue both with underwriting the policy and with the costs of insurance (even if the client is healthy). The other problem is that if the clients intend to take income tax-free loans from the policy, they better wait at least 10 years if they want to get a decent flow of sustainable loans from the policy.
If Dr. Smith purchased an indexed equity life insurance policy on his life and he was “standard” health for underwriting and he repositioned the $420,000 left after the sale of the old house (remember the $100,000 remaining debt that needs to be paid off) and an $80,000 down payment on the new $500,000 condo, he could borrow income tax-free from the life policy $35,000 a year from ages 70-84 (I assumed a 7.5% rate of return in the indexed life policy)
What if he repositioned the $420,000 into equity index annuities (EIAs)? If the annuities returned a reasonable 5.5%, the client would be able to withdrawal $67,747 a year for the same 15 year period (70-84). If the annuity was annuitized, the client would have the following left after taxes: $51,314 in the 40% income tax bracket, $55,422 in the 30% bracket and $61,585 in the 15% bracket. All of the after-tax withdrawals out of the annuity beat the tax-free income from the life insurance policy.
What if Dr. Smith repositioned the $420,000 into the stock market earning the same 7.5% as the equity indexed life insurance policy? If we assume a 20% blended capital gain/dividend tax rate annually on the growth and a 1% mutual fund expense (no money management fee however), Dr. Smith could remove $62,773 after-tax from the brokerage account ever year for the same 15 year period (ages 70-84). This is slightly more than the money that can be removed from the EIA after-tax, but in the stock market, there is NO protection if the stock market goes in the tank. With the EIA, the client has principal protection (and maybe even a guaranteed payout).
FYI, if we assumed Dr. Smith was in “preferred” health for the underwriting of his cash value life insurance policy; he could borrow $43,000 income tax-free every year from age 70-84.
What about using home equity management to help a client with estate planning?
Let’s take our same Dr. Smith and assume he will not need any of the money in his IRA to live on in retirement. There are millions of clients who will not need some or all of the money in their IRAs in retirement. What would happen if Dr. Smith sold his home, downsized into a condo, and then systematically gifted the $420,000 to an irrevocable life insurance trust (ILIT) where a large death benefit could be purchased? A death benefit in excess of $2,000,000 would pay if he died at age 84. The death benefit would pass income and estate tax-free to the heirs.
If Dr. Smith does what most people do (which is nothing), the $400,000 IRA will grow and pass through his estate? The $400,000 would grow to $1,715,748 and be double taxed when he dies leaving $429,127 for the heirs after income and estate taxes.
When using Equity Management to help reduce the income and estate-taxes on IRAs AND when trying to generate MORE income in retirement using a cash value life insurance policy, it is very very difficult to make the numbers work even if the client who is over the age of 60 is healthy.
However, using equity management to remove money from an IRA where the equity raised is gifted to an ILIT and used to purchase life insurance for estate planning purposes is a terrific idea and one you can use when talking with clients who have estate tax problems and money in their IRAs that will not be needed in retirement.