A Strategic Way to Address the Tax-Deferred Disconnect

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As of the second quarter of 2024, Americans had $40 trillion in pre-tax retirement accounts, such as 401(k) plans, 403(b) plans and IRAs, according to the Investment Company Institute. These accounts are fully taxable at ordinary income tax rates to either the owner or the inheritor of these accounts.

Under current law, once a pre-tax account owner is age 73, they’re required to begin taking required minimum distributions (RMDs) for life or until the account is depleted. As a financial adviser since 1996, I’ve typically seen one of two scenarios unfold: Some individuals withdraw funds, pay their taxes and spend the money. Others invest the withdrawn funds in another tax-deferred or taxable account, which either increases their own taxes or defers additional taxes for their heirs. I refer to this as The Tax-Deferred Disconnect.

For those who don’t need the income, there are strategies and techniques available to leverage the required minimum distribution to offset the tax burden on these accounts. Today, I’m writing about one such strategy.

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Let’s review a hypothetical example:

George, age 65, has a $500,000 IRA and does not need to withdraw or spend these funds to support his family’s lifestyle. His wife, Gayle, is 64, and they have two children.

At age 73, George begins taking his RMDs and pays his taxes on those distributions each year. At age 80, George passes away, and Gayle, now 79, inherits the IRA. Assuming modest annual growth and continued minimum withdrawals, the account value should grow while Gayle owns it.

At age 90, Gayle passes away, and the children inherit the IRA, which has grown, hypothetically let’s say, to $600,000. Each of the two children inherits $300,000, which they could either take as a lump sum or withdraw over a maximum of 10 years, paying taxes on each withdrawal. If the children have had successful careers and are in higher tax brackets already, these distributions could push their taxable income higher and possibly make everything else on their tax return more expensive.

Think differently

If George and Gayle won’t need the income, they could consider alternative strategies that avoid passing a large tax burden to their children. For example, they could donate the IRA to a favorite charity at death and replace the taxable IRA with a tax-free life insurance policy of equal value for their children to inherit. 501(c)(3) non-profit corporations are tax-exempt and they would receive the IRA funds tax-free. Here’s how it could work: Withdraw a small amount annually from the IRA, pay the taxes, and use the after-tax funds to pay the premiums on a $600,000 life insurance policy. Life insurance benefits are typically tax-free, so the children inherit $600,000 tax-free, and your favorite charitable organization would inherit $600,000 tax-free.

The Tax-Deferred Disconnect happens when account holders fail to realize that they could be leaving their heirs with a substantial tax liability, significantly reducing the value of their inheritance, in lieu of discovering planning strategies to mitigate the future tax liability of qualified retirement accounts.

Possible next steps

Proactive planning helps ensure your wealth benefits your loved ones and your values while mitigating unnecessary tax costs.

Review your beneficiary designations. Ensure your IRA and retirement accounts have up-to-date beneficiaries.
Reevaluate your insurance options. Discuss the potential of leveraging life insurance to replace taxable dollars with tax-free dollars. A financial professional could help design a plan that aligns with your legacy goals.
Implement a Roth conversion strategy. Consider gradually converting portions of your traditional IRA or 401(k) into a Roth IRA. Though this requires paying taxes on the converted amounts in the year of the Roth conversions, the funds grow tax-free and could be withdrawn tax-free by your heirs, reducing their future tax liability.

The bottom line

You don’t have to accept the Tax-Deferred Disconnect as inevitable. With proactive and thoughtful planning, you could maximize your legacy while reducing tax liability. By leveraging strategies like charitable donations and tax-efficient life insurance planning, you could turn potential tax dollars into meaningful contributions and tax-free inheritance for your loved ones.

Imagine leaving behind an efficient transfer of your qualified assets to your heirs and also a legacy that funds causes close to your heart — whether that’s supporting a cancer hospital, funding scholarships or simply reducing the tax burden to your heirs. It’s not just about managing taxes — it’s about taking control of your financial legacy.

Insurance products and services offered by Jim Sloan & Associates, LLC. Investment advisory services offered through MariPau Wealth Management, LLC an SEC Registered Investment Advisor. Please note that the use of the term “registered” to refer to our firm and/or our associated persons does not imply any particular level of skill or training. Melton & Company, LLC and MariPau Wealth Management, LLC are not affiliated entities. While the processes mentioned in this article have been designed with care, financial outcomes can never be guaranteed as investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. None of the information contained in this article shall constitute an offer to sell or solicit any offer to buy a security or any insurance product. Insurance may be subject to fees, surrender charges and holding periods which vary by insurance company. The information and opinions contained in this article are provided by the author and have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. They are given for informational purposes only and are not a solicitation to buy or sell any of the products mentioned. This article is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual’s situation. Jim Sloan and Jim Sloan & Associates, LLC do not give tax or legal advice. Tax laws are subject to change and can affect results. The firm is not affiliated with the U.S. government or any governmental agency. Hypothetical examples have been provided for illustrative purposes only and should not be construed as advice designed to meet the particular needs of an individual’s situation.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Jim has written six books to help those approaching retirement become informed and get the relevant facts and math on the table when making major financial decisions. He is an Investment Adviser Representative and a licensed insurance agent. Jim has been featured in or seen on local and national media outlets for his perspective on financial topics pertaining to Baby Boomers and other retirees, such as The Wall Street Journal, Forbes, Fox Business, MarketWatch, Reuters, Fox 26 Houston, The Denver Post, the Houston Medical Journal and others. Jim also teaches a six-hour financial education course, Retiring Well in the 21st Century, at multiple college campuses in Texas.