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Section 408 Trusts – The Tax Shelter Every Business Owner Should Use

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12/19/2012

How to Pass It On to Your Heirs


Every small business owner should use one tax shelter every year. It may mean the difference between retiring comfortably and not retiring at all: a Section 408 trust. A Section 408 trust gives you the ability to earn money, avoid paying tax on it today, transfer it into a savings plan where it grows without a tax, invest it basically anywhere you want, and then only pay the tax when you spend the money years down the road. That is a big deal.

For seven years, I wrote a column every month for the Physician's Money Digest. It went out to over 300,000 physicians, and I would get many calls from doctors wanting to know how they could get a little better return on their investment. I always asked one question back: "What's the tax?"

Tax is the most important consideration in an investment. When Congress created 408 trusts in 1974, I am convinced that they did not understand the impact that taxes (or the lack thereof) have on an investment. They never envisioned the impact that 408 tax laws would have on investing. I am sure they only envisioned a little extra money that mom and dad could spend when they got old. They never saw millions of dollars in 408 trusts.

Your advisor may not understand Section 408 of the IRS Code. In fact, your advisor may not be familiar with 408 trusts at all. Ask him or her; if he or she does not know what a 408 trust is, it is time to get a new advisor, because the laws under 408 let you do many neat things - things your advisor may not have told you about.

It is good to have a 408 trust, and you should know how to use it. The way you learn how is by simply studying the law, i.e., Section 408 of the IRS Code. 408 trusts have special rules that allow these trusts to be passed on to your heirs, allowing the investments to continue to grow over their lifetime without a tax. That is a really, really big deal, but the trust has to be handled under specific protocols when you die. Very few advisors follow the protocols.

Section 408 defines something that you know as an IRA. Someone who knows the laws can make your investments sing, but if you do not understand 408 laws, you cannot make your IRA grow nearly as fast. I am not just talking about the rules of putting money in, getting a tax deduction, then taking it out when you are age 59, and the like.

I am talking about being able to have an IRA own real estate, run businesses, pay money out over your lifetime starting at any age, and do lots of other things most people do not know they can do.

Standard IRA vs. Roth IRA

One of the questions people have is whether they should contribute to a standard IRA or a Roth IRA. A standard IRA contribution will give you a tax deduction, and then you pay the tax when the investment is taken out of it.

The tax deduction is a special type of deduction. It is not just a "standard deduction." It actually lowers your Adjusted Gross Income (AGI). In fact, it is one of the few things an individual can do to lower their AGI. Always check to see what affect a standard IRA contribution will have on your annual tax return. If the deduction lowers your AGI and puts you in a lower tax bracket, by all means, use a standard IRA that year.

Is there an economic advantage to a standard IRA or a Roth IRA? The following chart runs through a little sequence and shows what would happen if you have earned $5,000 that you want to put into either a Roth IRA or a standard IRA.

Note that you do not get to invest the entire $5,000 into the Roth, because you have to tax the $5,000 before you can put any money into it. The full $5,000 goes into the standard IRA because it is a deductible dollar.

When money comes out of the standard IRA, all of this money has to be taxed. Making the assumption that returns on investments are the same and that you pay a 25 percent tax on the money, you can see that the results of investing in a standard IRA and a Roth IRA are identical. The money you will spend in retirement is the same.

That is a little surprising; because you have always been told that the Roth IRA was the "end all, do all" of investing.

This chart makes one bad assumption: It assumes that the tax rates remain the same throughout the period. Tax rates change a lot. If taxes are going to be higher when you retire, you want to use a Roth IRA. If they are going to be lower, you want to use a standard IRA.

Today, tax rates are at an historic low. Believe it or not, that is true. Taxes are going to go up – way up. I am convinced more than ever that politicians do not understand taxes. Our economy will die when taxes go up, but it is safe to say that the tax rate will be higher when you retire than it is today.

If you know taxes are going up, the Roth really is neat. You may not have a Roth IRA. Many people would love to be putting money into a Roth, but they have never qualified.

If your AGI is over a certain amount (approximately $170,000) in a year, you cannot create or contribute to a Roth IRA in that year. There are many ways to lower your AGI, but you need to start today. Your options are limited at the end of the year.

Inherited IRAs

Your IRA is the most valuable investment that you can leave to your heirs. However, most kids blow their opportunity when they get an "inherited IRA." One of the most important things you can teach your kids is the financial secrets of an inherited IRA.

An IRA can be "stretched" over the lifetime of the person who inherits it. One of the most important financial concepts you can teach your children is the power of an inherited IRA. That cannot be said too many times. It is really important!

Most kids are either ignorant or just naive. As soon as they get their hands on the IRA, they think that it is "free money." They take the money out of the IRA and go to Hawaii. What they do not realize is that is the most expensive trip they will ever take by a factor of ten.

There are many rules to follow, but if you can teach your child to keep the IRA, it will produce income for them for the rest of their life. You know the miracle of compounding interest. Having the IRA growing tax-free over the next generation's life is compounding interest on steroids.
Even a moderate IRA can produce millions of dollars over the next generation's lifetime. If you can leave your IRA to a grandchild and have it grow during the 80-year life of the grandchild, the grandchild will get to spend a great deal of money. It is the best inheritance they can get, but they have to know what to do with it.

You have to teach your heirs to keep the IRAs and not cash them in. Make sure they know how to follow all of the rules so that the inherited IRA can be "stretched" over their lifetimes. The family has to file papers with the IRS and jump through some hoops, but there is no question: it is worth all that effort.

The person who inherits the IRA will have to immediately start taking out required minimum distributions based on his or her own life expectancy. The facts are, even with a conservative investment, the IRA will grow faster than when money is taken out as required minimum distributions.

Note that an IRA is a trust. It should almost never have an estate planning trust as its beneficiary. Remember to always make a "person" the beneficiary. Simply put, an inherited IRA can be a money machine for the person who inherits it. Make sure everybody understands what has to be done to make the machine work.


Attorney Lee R. Phillips is a nationally recognized expert in the field of financial and estate planning. Lee is licensed to practice law before the United States Supreme Court and also holds licenses in insurance and securities.

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