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Avoid double whammy on retirement funds

by on
in Small Business Tax,Small Business Tax Deduction Strategies

If you’re able to retire with a small fortune in your company retirement plan, you’re way ahead of the game. But too much of a good thing can turn into a bad thing.

Specifically, if you should die with most of your nest egg intact, your family could get walloped by income tax, on top of a hefty estate-tax bill.

Strategy: Use your retirement plan funds to buy life insurance coverage.

When you pass away, those life insurance benefits are free from federal income tax to your beneficiaries. They can then use the cash to pay off the tax bills and pocket the rest.

You’re required to begin taking annual distributions from your employer-sponsored retirement plan after you reach age 701/2 anyway. Since you have to take cash out of the plan, you might as well put it to good use by purchasing life insurance coverage.

Here’s the whole story: While you’re working, you can accumulate funds in a company retirement plan, such as a 401(k), pension plan or profit-sharing plan, without paying any current tax on the buildup. Even if you retire early, you don’t have to tap into the plan until after reaching age 701/2.

However, if you die before the plan funds are paid out, the balance must be distributed to your beneficiaries. For non-spouse beneficiaries, the funds generally must be distributed over a period based on the beneficiary’s life expectancy or, in some cases, over no more than five years. The distributions are taxed to the beneficiary at ordinary income tax rates. Also, the plan funds available at death are included in the value of your estate for federal estate-tax purposes.

That creates a double tax whammy: First, the estate tax is applied to the plan assets, and then the beneficiaries must pay income tax on the distributions required by law. 

Example: Say you have $1 million in your retirement plan that you’re leaving to your child, the sole beneficiary. That exposes the retirement plan assets to federal estate tax at the 45 percent rate when you die, so your child receives only $550,000 ($1 million minus $450,000 estate tax). The child takes a lump-sum distribution, taxed at the 35 percent income tax rate.

In the end, your child is left with only $357,500 (65 percent of $550,000) from the $1 million you scrimped and saved all these years. And that’s not even counting any state and local tax erosion. When you figure in those extra taxes, family members can easily forfeit more than 70 percent of the retirement plan funds.

Although insurance premiums may be relatively high for someone nearing retirement, the payoff is generally worth it. With proper advance planning, there’s no federal income tax or estate tax due on life insurance proceeds.

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