Pity the professionals who retire with $1.5 million or more in their individual retirement accounts. The nest egg they have so generously funded over the past two decades may be wiped out in a 1-2-3 tax punch from the Internal Revenue Service. Perhaps more accurately, pity their iids, who may find themselves forking over as much as 90% of their inheritance to Uncle Sam if Mom and Dad didn't plan correctly.
The conventional wisdom--contribute the maximum to a qualified retirement plan or IRA and let the income and gains compound tax-deferred--doesn't apply in the case of mega-IRAs. If your qualified plan is over $1.5 million by the time you are 60, think twice before pumping in more money. You may even want to withdraw funds early. "The pension assets of many professionals may represent 35% to 50% of their net worth," says Steven Lockwood, a pension attorney and president of Lockwood Pension Services in New York. "While this may be good for their retirement security, it's an estate-planning nightmare."
That's because at age 70 1/2, you must begin taking minimum withdrawals each year based upon an IRS formula that considers life expectancy and the amount in the plan. Any distribution above $150,000 is subject to a 15% excise penalty, also known as the "success tax," on top of ordinary income tax. Unfortunately, this excise tax follows you to the grave. If there's too much left when your children or other nonspousal heirs inherit the plan, they may have to cash it in to pay all the estate, income, and excise taxes, leaving them with as little as 10% of the total.
TRIPLE THREAT. But there are a few strategies you can implement now to avoid this scenario. The larger the account grows, the more you will eventually end up paying to the IRS. "People forget that the dollars in the plan are soft dollars, so it's a deceptive amount because of the triple taxation," says Kenneth P. Brier, a tax attorney with the Boston law firm of Sherburne, Powers & Needham. So just say no to additional contributions that would take you above the $1.5 million threshold.
Another way to keep the plan from mushrooming is to realign your investments. For large IRAs, significant growth is no longer a goal; the key is to maintain a steady rate of return. You can do that by investing IRA assets in fixed-income securities while keeping equity holdings in your regular portfolio. This strategy has other benefits: Profits on any stocks bought and sold outside your IRA are taxed at the lower capital-gains rate, not as ordinary income. And when you die, the appreciation of the stocks outside the IRA is tax-free.
If your plan already is overgrown, start taking distributions after age 60 but before 70 1/2. Even though you will be paying income taxes now, you can reduce the tax burden in the long run by pruning the plan to a level that won't trigger the excise tax. Lockwood cites the example of a 63-year-old attorney with a $2 million IRA and a $5 million net worth. Following the advice of his accountant, the man had been contributing the maximum to his law firm's qualified plan for 28 years. Because he had other assets to live on, he wasn't planning to touch the money unless he had to, figuring he would leave most of it to his kids.
SNOWBALL PLIGHT. But Lockwood showed him that if he continued to deposit $30,000 annually until retirement without withdrawals, the plan would snowball to $3.5 million by age 70 1/2 (assuming an 8% annual return). So Lockwood's client decided to take money out early, paying 45% in income taxes now instead of shelling out 60% in income and excise taxes later.
Then, to protect his children's inheritance, he bought a second-to-die life-insurance policy to cover future estate taxes. The policy is owned by an irrevocable trust, with the kids as beneficiaries, thus exempting the death proceeds from estate tax. The policy can be funded by withdrawals from the IRA and by making annual gifts to the children.
That lawyer isn't alone. In 10 to 15 years, mega-IRA problems will be much more common. "When the baby boomers start retiring, you'll see some very large balances, especially if this incredible march in the stock market continues," says David Wray, of the Chicago-based Profit-Sharing/401(k) Council of America. And owners of those heavyweight retirement accounts should remember that the more you sock away, the more the IRS may sock it to you in the end.