Select Page

This is adapted material from a talk Christopher Jacob gave in 2017 about qualified plans and a video featuring Chris Jacob from Steve Savant’s Money: The Name of the Game.

We left off Part 1 of this series with a question: Do you know what $21,178,131,878,700 represents?

You’ll find out the answer soon. But first, I have a business proposal for you. I want to go into partnership with you and here’s my proposition: You put up 60% of the money and I’ll put up 40%. You take all the risks and put in all the sweat equity. And, down the road, when the business is profitable, I, as the minority partner, will decide how we’re going to divvy up the profits.

Who wants to sign up for that? No takers?

Well, look. You’ve got a silent partner in these [qualified] plans with you and it’s a good thing he’s not sensitive because you never mention him.

Take a look at this graphic. We call it the Personal Economic Model. The tank on the left represents your qualified plan. Can you identify what the red is? Is all that money your money? No. That’s the government’s share.

Investment Savings Diverter | Christopher Jacob Missouri
Let’s go back to that number, $21,178,131,878,700. What does it represent?  That is the U.S. National Debt.

U.S. National Debt | Christopher Jacob Missouri
A certain senator from California was being interviewed and when asked about the massive federal debt, especially how it’s been run up under the last administration, her response was, “Balance-sheet wise, we don’t have debt.” The interviewer questioned her statement. The senator tried to clarify, “Yeah, we have $21 trillion in debt, but we have $25 trillion in IRAs and 401ks that have yet to be taxed.” Where do you think they’re going to get it?

Retirement Theft Graphic | Christopher Jacob Missouri

Do you ever notice what word you get when you squeeze together “The” and “IRS?” Theirs. And that’s the way they think about it.

Theirs: The IRS | Christopher Jacob Missouri

So, do you want to pay tax on the seeds or do you want to pay taxes on the entire harvest? And what happens when it comes tax-harvest time with these plans?

I had an individual come to me, and he said “Chris, I don’t owe anybody anything. I’m completely debt-free.” I said, “Really? How much do you have in your IRA?” He said he had $1 million. I told him, “Well, maybe that’s what your statement says, but let me show you how it should read.” It should show that $600k is yours, and that $400k belongs to your favorite uncle, “Uncle Sam,” otherwise known as the IRS. What’s the exit strategy on that money?

Exit Strategy Graphic | Christopher Jacob Missouri
Have you ever heard of these stages of life: Desire, Perspire, On Fire, Retire, Expire? What happens at Expire with these plans? Well, if it passes to the next generation, and if the estate’s large enough and it will be subject to estate taxes, not only is it hit with the estate taxes, it gets hit with income taxes, too. So, in essence, Uncle Sam becomes a bigger beneficiary of these plans than your heirs.

Worth of Qualified Plan Assets | Christopher Jacob MissouriMark Twain once stated that, “The only difference between the taxman and the taxidermist is that the taxidermist leaves the skin.” It feels that way when it comes to these types of plans.

What do I do about all of my government controlled money? I’ve got money locked up in these plans, and how do I get dollars out of those plans on a tax efficient basis?

Well, first of all, let’s define the difference between tax avoidance and tax evasion. The difference is in the view. Tax evasion will land you about 20 years behind a set of bars.

What we can talk about, though, are clear tax avoidance measures that are right in the code. Depending on your goals, these measures will allow you to increase your after-tax income, and leave more money to heirs or charity. So, how does it do that?

First, let’s take a look at the problem.  What is the embedded tax on a qualified plan?  Assume an individual has $1,000,000 in qualified plan assets and he’s age 50, We will further assume he earns 6% on his money. He is going to let it grow and at retirement age 65 he will have accumulated $2,540,354 in his plan. See the table below.

Asset Values | Christopher Jacob Missouri
That was the accumulation phase.  What happens in the distribution phase?  Let’s solve for a level distribution, starting at age 66, that depletes the account by age 90.

As we know, these plans are not tax-free, they are tax-deferred, or as we call them tax-postponed. And as I like to say, “Webster’s definition of gross is ugly, and you can’t spend it!” How much tax is he going to pay? Well, in his million dollar qualified plan with a 30% bracket, he currently has an embedded $1.4 million tax. What if tax rates go to 40%? Now he’s got an embedded $1.8 million tax.

Income Summary | Christopher Jacob Missouri

There is a little known strategy that we refer to as, “The Pension Optimization Plan” that legally allows you to take money that’s on the taxable side of the wall and get it over to the tax-free side, and this is accomplished with one of the greatest financial tools available, life insurance.

Power of Pension Optimization Plan | Christopher Jacob Missouri
So how does it work? We have a profit sharing plan purchase a life insurance policy with pre-tax dollars, usually funded over 3-5 years.   This can not be done inside and IRA, but you can roll an IRA to a profit sharing plan that does allow for the purchase of life insurance as a plan asset.

Buy Life Insurance | Christopher Jacob Missouri
We are ultimately going to transfer the policy out of the profit sharing plan for something called Fair Market Value (FMV). FMV is clearly defined in Revenue Procedure 2005-25 back in 2005. So, we’re using government rules to determine what is the value of the policy for tax purposes.

| Christopher Jacob Missouri

And we will pay that tax with a loan from the life insurance policy.

| Christopher Jacob Missouri

Let’s look at Mr. Stinson, age 50, with $1,000,000 of qualified plan assets.  He would like to start receiving $175,000 of after-tax income starting at age 70.  How long will that last him? Well, not very long. Because even assuming a 30% tax bracket at retirement, he will have to pre-tax withdraw $250,000 to net the $175,000.

Bill Stinson Case Study | Christopher Jacob Missouri
Let’s quantify that tax on an annual and a cumulative basis.The $75,000 annually adds up quick.  So, by the time the money is depleted at age 75, he will have paid a total of $764,316 in income taxes.

Stinson Retirement Income Tax | Christopher Jacob Missouri

And, upon his death, something called, “Income in Respect to a Decedent”, or IRD tax, will be due.  Meaning when a non-spouse beneficiary receives the proceeds from the qualified plan, ordinary income tax, at the beneficiary’s tax bracket, will be assessed as seen in the table below.

Heirs' Tax Rate | Christopher Jacob Missouri

Let’s take a deeper look at the Pension Optimization plan. We’ve got the same figure of one million dollars in retirement assets, but now we also have $4,108,685, which is the minimum death benefit that we can get to accommodate what we want to fund this policy with.

Current Assets | Christopher Jacob MissouriThe policy is going to be funded with $219,736 a year for five years. Then we are going to transfer it out, at which point there will be a tax on the FMV. At the end of year five, the Fair Market Value is projected to be $813,710. In a 40% bracket he’s going to have a $325,484 tax liability.  He will then borrow that amount from the insurance company by taking a loan against the cash value.

Think about this: you’re paying the tax with someone else’s money, and that money is still growing for you inside of the policy..  Notice that the value in the policy appreciated net of the loan that is because you are borrowing against the policy and not from the policy.  And, this still leaves us with enough policy value to generate a projected, but not guaranteed, $1750,000 of tax-free income.

There will still be sufficient value left in this policy to generate $175,000 of tax-free income during retirement. This runs all the way out until age 120.

Christopher Jacob Missouri

So he still wants a $175,000 for spendable cash flow, but also needs what we will call, “dedicated cash flow” of $219,736 for five years to fund the policy, and $325,484 to pay the tax levied on the FMV when the policy is transferred.

Cash Flow | Christopher Jacob Missouri
And, as you can see below, the new life insurance policy is funded with pre-tax dollars from the qualified plan.

Assets Over Span of Time | Christopher Jacob Missouri

Cumulative Retirement Assets | Christopher Jacob Missouri

But we’re not done. Let’s look at the total income that was produced. The cumulative spendable cash flow provided by age 89 by sticking to the status quo would earn you only $1,783,404. The Pension Optimization plan would earn $4,375,000. That’s almost 2.6 million dollars more in net after-tax cash flow for significantly less tax.

Cumulative Spendable Cash Flow | Christopher Jacob Missouri

And what about the heirs?   They are a clear winner throughout.

Wealth to Heirs | Christopher Jacob MissouriThe chart below kind of speaks for itself, doesn’t it?  Pay less taxes, with borrowed money, and generate substantially more income.

Retirement Plan Taxes Paid | Christopher Jacob Missouri
You wind up with more. Your heirs wind up with more. The government still gets the taxes they are due. This plan is doable at age 50, 55, 60 and 65, and of course is even more beneficial the earlier you start.

Einstein once said, “The significant problems we face today cannot be solved at the same level of thinking we were at when we created them.” That definitely holds true when it comes to qualified plans. You have to think outside of the box about how to solve this embedded tax problem that is looming and getting larger all of the time.

Chris Jacob is a Registered Representative with Saxony Securities, Inc. Securities offered through Saxony Securities Inc. (SSI). Member FINRA, SIPC. Non-security products and services or tax services are not offered through SSI. Cadeau is not affiliated with SSI.