Tax Planning Lessons From the CIA

Let’s look at a specific example. Last week, I spent some time with a 41-year-old real estate entrepreneur. He earns about $500,000 and stashes about $200,000 of that in a cash balance plan. He also has about $400,000 in traditional IRA assets. And he’s charitably inclined – he gave about $30,000 in 2019.

At first glance, the cash balance contribution looks like a home run. But at his age, the Rule of 72 tells us that investing his existing IRA balance at 8% should grow to $800,000 around age 50, $1.6 million around age 59, $3.2 million at 68, and $6.4 million at 77. Would he really want or need more traditional assets, considering how much the IRS would take of those balances?

Here’s what we had to consider:

• The entry level question was how much he’s saving by contributing to the cash balance plan. Without the plan, he’s “in” the 35% bracket. But of course that doesn’t mean he’s saving 35 cents on every dollar he contributes. Dropping $200,000 into the plan takes him all the way down to the 24% bracket. Plus, there’s a cost to administering the plan and contributing on behalf of an employee. We figured he well under 30 cents on the dollar today.
• What will his tax rate be when he starts pulling money out of the tax-deferred bucket? Your guess is as good as mine – if we’re lucky, the earth will be hit by a comet before then. But odds are good that rates are going back up over time, and he’ll actually pay more than he saves today. Es no bueno.
• What about his charitable giving? How much is he really saving with that? The plan contribution means he’s deducting 24 cents on the dollar at the federal level. Is there a way, perhaps, to concentrate some charitable gifts to get a bigger deduction?
• What opportunities might we have to eliminate the enormous future tax bill on his current tax-deferred account balance?
• How will the Biden administration’s tax proposal affect these calculations? Would it make sense to accelerate any deductions into 2021 if the top rate is going up in 2022? Do we want to recommend any major moves before we see some specific legislation, or have some assurance that it’s going to pass?

Take a couple of minutes to gather your own considerations. Play the home game before you finish the rest of this column!

Ok, what did we come up with? I have a terrific plan that can leverage current deductions to eliminate literally millions of dollars in future taxes and help assure the client’s legacy for his two young children.

My specific recommendation was to establish a charitable lead annuitrust to accelerate future charitable gifts. Then, instead of squandering those deductions at 24-ish cents on the dollar, use them to offset the income from converting the $400,000 in traditional IRA assets to Roth assets. The account will grow to the same eye-popping numbers we discussed earlier – but now they’ll be tax-free. That move alone could easily save $2 million or more in  lifetime tax. (Along the way, it’ll make the $10,000 planning fee he paid the best investment he’ll ever make in his life.)

Of course, we’ll want to wait until later in the year before pulling any triggers. And the client is suddenly less excited about his cash balance plan. So we’ll talk about shifting some of his retirement savings into cash-value life insurance for even more tax-free retirement income. His kids are young and he needs a ton of coverage anyway.

Granted, this sort of planning isn’t as fun skulking around behind the Berlin Wall in 1980s East Berlin. On the bright side, tax pros rarely get a bullet in the brain while working. But the lesson from the CIA test remains. Tax planning isn’t an exercise in following the rules, or even making the most of the rules. It’s an exercise in creative thinking, and gathering all the considerations in one place to come up with the best results for your client!