Pre-Planning with Tax-Qualified Funds

July 13, 2010 - PRLog -- When trying to pre-plan with tax-qualified funds, whether the planning is for Medicaid or VA benefits, we all know that the primary goals are to get rid of excess assets, while minimizing tax liabilities. A balance must be created between program eligibility and tax consequences, a task with which very little text and guidance is provided in order to accomplish. In a handful of states, retirement funds owned by an ineligible spouse or even an institutionalized individual are simply considered exempt from resource limits for Medicaid purposes, thus pre-planning arrangements may not be required. But, what can be done in the states that are not afforded this luxury?

In crisis Medicaid planning, the most advantageous option is usually clear - convert the retirement funds into a Tax-Qualified Medicaid Compliant Annuity. However, in pre-planning, the decision is not as simple, and the pros and cons of the available options must be carefully weighed prior to proceeding.

If the tax-qualified funds are to be gifted away, the applicant will need to subject the entire account to income tax before any gift can take place. The net result, in that a large amount of income in any one year can be subjected to higher tax brackets, is that the gift amount will be significantly reduced.

What if the applicant transfers the tax-qualified funds to an intentionally defective grantor trust, which is not a completed gift for tax purposes? Based on the Internal Revenue Code ("IRC"), particularly IRC 408(e)(2) and IRC 4975(c), it is clear that the Internal Revenue Service will treat the transfer as a "prohibited transaction." As a result, the applicant will be forced to recognize a taxable event of his or her entire account value as of January 1st in the year which the prohibited transaction occurred. The end result is nothing short of total devastation.

So what is the best pre-planning strategy when tax-qualified funds are involved? In my opinion, the most advantageous option is an Irrevocable Life Insurance Trust ("ILIT"), which is controlled by the grantor's children - as Trustee. The ILIT purchases a life insurance policy on the life of the owner of the tax-qualified funds, and the face value of the policy is equal to the account balance. In order to give the ILIT sufficient assets to pay future life insurance premiums, it is best if the applicant makes a large gift at the commencement of the plan. If the gift amount exceeds $13,000 per person, it will be necessary for the applicant to file a gift tax return - IRS Form 709.

For example, if a 75 year old male with preferred health and no history of tobacco use has an IRA valued at $500,000, the Trustee could purchase a 20-year level term life insurance policy with a $500,000 face amount for an annual premium of $20,003. According to the National Center for Health Statistics, a 75 year old male is only likely to reach 85 years of age. Thus, the likelihood that a 75 year old male will reach 95 years of age has a less than 3% chance. By age 85, the value of the IRA account will be reduced to $281,650 - his 2010 required minimum distribution requirement is $21,835, but the ILIT will still have a net of $500,000. If the 75 year old male were able to gift away $200,030 at the commencement of the plan, and stay out of a Medicaid situation throughout the 5 year look-back, the plan is a home run!

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