July 2003

Is Your Money Overqualified?

(The Case Against IRAs)

            I have spent my career advising clients on contributing to qualified retirement plans, such as pension and profit sharing plans and 401(k)s. 

            I would now like to present the contrarian’s point of view: Why loading up on qualified plans can be bad for your estate planning health.

            Have you noticed that with the decline in the stock market that started in March 2000, investment advisors have been preaching “asset allocation?”  If you spread your investments into lots of different categories---large cap stocks, small cap stocks, value stocks, growth stocks, foreign stocks, corporate bonds, government bonds, real estate, pork bellies, gold, etc., --- you’ll make lots of money.  Or, you won’t lose as much.

            For all this talk about “asset allocation,” however, there has been very little said about the broader question of allocation:  how much should you have in “pre-tax” investments, such as in qualified plans and IRAs, as compared to your “after tax” investments?  Many of our clients miss the boat on this one, and miss it badly.  They have “over-allocated” into pre-tax investments and then find themselves with few planning options.  I have heard few “experts”  suggest putting less into qualified plans and more into after-tax investments. 

            In this memo I will discuss the problems of overindulging in pre-tax investments and what you might do about it.

            Background      Pre-tax investing became all the rage in the seventies.  Congress passed ERISA, the federal pension law, in 1974, and it permitted enormous pre-tax contributions to pension and profit sharing plans.  Our clients set up complex qualified plans and put every nickel they could into them.  The combined federal and state income tax rates were stratospheric--- 70% or more --- so socking away money into a qualified plan and getting a full deduction was a no-brainer.  In those “good old days” qualified plans could, through complex pension rules manipulated by weasels like me, be spring-loaded in favor of the business owners.    

            Many of our estate planning clients who benefited from that tax environment are now in their mid-fifties or older.  Because they overloaded on retirement plan contributions, they have large IRA balances and little, if anything, in after-tax investments.  The typical retired doctor or business executive has $2 million in his IRA, a paid off house, and not much else.  For these clients, estate planning options are restrictive.  All that money in the IRAs will eventually be subject to income tax, and perhaps the estate tax. 

            Problems of IRA Overload    From the most simple to the complex, here are the problems of an imbalance of a client’s wealth in IRAs.

·        Husband and wife are 68, retired, have total assets just under $1 million, including IRAs of $750,000.  This is a first marriage.  The couple wants to conserve assets “for their old age,” so they are reluctant to withdraw from the IRAs and pay the taxes.  The only “steady” income is from social security.  They would like to help the kids (and grandkids) buy houses or pay tuition, but they are guilt-ridden about dipping into the IRAs.  They fret with each day’s fluctuation in the stock market and the lingering fear of nursing home expenses.  On paper they are “wealthy,” but they don’t enjoy it.

·        Husband and wife are 60 and have assets of $3 million including husband’s IRA of $2 million.  The kids are grown and this is a first marriage.  They feel wealthy and want to live that way.  Estate taxes worry them.  They each have disclaimer trusts in their wills, but no liquid after-tax assets to fund them.  The wife has few assets in her name alone.  The husband cannot transfer any IRA assets to the wife without paying the income taxes.  They considered life insurance, but at their ages it is too expensive.  They are interested in long-term care insurance.  

·        A 73 year old widow has three grown children and a $2 million rollover IRA from her late husband.  Her health is OK, but she will need living assistance in a few years, and most likely a nursing home later on.  She’s not worried about estate taxes.  She’s worried about outliving her money, because her own mother lived into her 90’s.  The widow wants to help her divorced daughter who is raising two children as a single mom.   The widow doesn’t want to take more than the minimum distribution from the IRA because of the income taxes.

·        Husband is 58 and wife is 45.  They have assets of $4 million, of which $2 million is in the husband’s IRA.  This is a second marriage for both.  They each have two adult children from previous marriages.  The husband needs the estate tax marital deduction if he dies first.  He wants to take care of his wife for her lifetime, but does not want to shortchange his kids of “their inheritance.”  And, he wants his kids to get “their inheritance” at his death, and not have to wait until his wife dies. He is uninsurable. 

·        A widow is 81 years old with an IRA of $750,000 from her late husband.  She must give up her apartment and move into assisted living, knowing that nursing home care will be necessary in a few years.  She’s been advised about Medicaid planning, and understands the urgency of making current gifts to her children and grandchildren.  She is consumed with worry about losing all her money to a nursing home and not leaving anything to her grandchildren.

            Solutions to the IRA Overload          In each of these examples, of course, there are planning tools available.  IRAs can be directed to special disclaimer and QTIP trusts, IRA beneficiary designations can be adjusted, and life insurance and long term care insurance are available.                   

            My point is this, however.  In each of these cases the “solution” is more expensive, more complex, and more uncertain than had the client had more “after tax” investments.    Even a small portion of assets in (gasp!) a conventional annuity or life insurance policy could be a great help in all of these examples.

            An annuity will produce a stream of steady income regardless of stock market fluctuation.  Even a relatively small amount of “supplemental” income every month can make a huge difference in the client’s comfort level.  Reducing a client’s anxiety level makes the rest of the planning job easier.  A permanent life insurance policy can work wonders also, even if it is small.  Beneficiary designations can be changed any time.  The policy can be transferred.  The payoff is certain.     

            Income tax rates may never be lower.  I am advising many clients who are not yet retired to pare down retirement plan contributions, pay income taxes currently, and make after-tax investments.  Roth IRAs are almost never a mistake if the client is eligible.  Annuities and life insurance should be added to the mix, even in small amounts.

            If the client is a business owner with a significant balance in the company’s qualified plan, consider terminating it.  Bonus out to employees the money that would have gone into the plan for them.  They can make deductible IRA contributions.  The new IRA limits are higher than many employees receive under a plan anyway.  If you don’t terminate the plan, at least consider amending it to exclude the owner.  The savings in administrative costs for terminating or simplifying the plan may pay some of the income taxes on the owner’s “lost” contribution.

            The New Tax World      With the pending demise (or at least reduction) of the estate tax for most of our clients, and the partial loss of the stepped-up basis rule, income taxes will drive planning.       

            Like old generals planning to fight “the last war” with outmoded tactics and technology, many “estate planners” are still fighting the estate tax war.  It’s all about income taxes now.  We will do many of our clients a great service by getting more of their wealth into after-tax investments and not overloading on IRAs.