Escape From The Tax Trap: Can You Become A Financial Mcgyver


In Wyle E. Coyote fashion, at the bottom of the dreaded Fiscal Cliff at the end of 2012, sat a large (albeit metaphorical) trampoline that propelled many of our clients into higher income tax brackets at a frightening speed. While federal estate and gift taxes remained largely unchanged, income taxes increased dramatically. As such, if you have not had the pleasure of doing your year-end tax planning for 2013, you might spit out your egg nog when you and your accountant tally Uncle Sam’s share of your income this year. Clearly, the reappearance of the 39.6% tax bracket and the 2% payroll tax along with tax rate newcomers—20% (capital gains), 3.8% (Obamacare) and .9% (Medicare increase) will combine with a 3% itemized deduction phase-out (Pease provision) to ensure that we’re all paying our “fair share.”

When the bad news hits, you could just say “Uncle” (and then in this case, “Sam”) and begin Dreaming of a Lean Christmas or engaging in the fruitless pursuit of playing the political blame game. Instead, as tax and financial planners, we endeavor to offer practical solutions to our clients that will not only enable them to keep more of what they earn now but also help them Escape from the Tax Trap that many of them have been unknowingly building for years. By way of example, below is a paraphrased excerpt from a discussion we recently had with Tom, a 59 year old gastroenterologist who is a relatively new client to our firm. Some facts: Tom owns 50% owner of his incorporated practice along with one other partner. They have 5 other employees (3 admin. and 2 nurses). His adjusted gross income is approximately $650,000 and he contributes the maximum to his SEP IRA annually. He has a substantial net worth including $500,000 in his SEP and $1.5 million in various after-tax investment accounts. Tom is very involved with 2 non-profits as a board member, volunteer and donor.

Me: Good morning Tom, how have you been?

Tom: Well, I just met with my CPA last week and I’m more than a little freaked out. He told me about all of the tax increases and that new itemized deduction phaseout along with Alternative Minimum Tax that I always seem to fall into and how it’s going to affect me. Let me tell you, it’s all a bit unsettling.

Me: What did he suggest you do?

Tom: Well, at first he suggested that I max out my SEP. But, after running some numbers, we figured out that I had already done that for the year. Then, he discussed the possibility of ‘hiring’ my wife and then taking her earnings and contributing the maximum we could to a SEP for her. What do you think of that strategy?

Me: Well, I think that could be a good anesthetic to relieve your immediate financial pain. But I’d rather discuss options to heal that pain at its source.

Tom: Ok. Now you’re talking my language, I think. What do you mean, specifically?

Me: Contributions to pre-tax retirement plans such as SEPs, 401(k)s, 403(b)s etc. delay the imposition of taxes rather than avoiding them altogether. So, by providing a short-term fix you create some long-term issues.

Tom: I see. But, I’ll be in a lower tax bracket when I retire so I’ll make out on the deal, right?
Me: Not necessarily. That seems to be an accepted ‘truth’ in financial planning but let’s look at that chestnut critically. You’re familiar with the $17 trillion deficit and the $125 trillion unfunded liabilities of the U.S. government?

Tom: Yes, we were in New York City a couple of weeks back and when I looked at the debt clock I almost threw up my corn beef sandwich from the Carnegie Deli. It’s simultaneously alarming and depressing.

Me: Well, there are only 2 ways the government can deal with this debt: Spend Less or Tax More. Which do you think they’re inclined to do?

Tom: Ok, I get your point.

Me: Also, let’s look at tax rates in the context of history…since the Temporary Income Tax was levied in 1913, the average tax rate has been much higher than it is currently.

Tom: So, I could actually distribute the money from my SEP at a higher tax rate than I was able to deduct when I contributed it. Ugh. Great! But it’s too late now, the money is already trapped in there. I’ll just begin taking it out when the government forces me to—at age 71, right?—and roll the dice. Let’s talk about what I can do to lower my current income tax bill without trapping me in the same predicament.

Me: We do have strategies to lower your current income tax—beyond your SEP IRA—that we’ll discuss at our next meeting. For now, let’s talk about converting that SEP to a Roth IRA so you won’t be taxed on that money again.

Tom: Hang on…I’ve already looked at a Roth conversion and I’m not interested in paying all those taxes up front. That would be a huge hit.

Me: I understand. Many of our clients feel the same way. That’s why we suggest a structure that will enable you to offset a big chunk of those taxes when you convert your traditional IRA to a Roth.

Tom: Sounds either illegal or too good to be true…which is it?

Me: Well, neither, of course. The idea is to take about $1 million of your brokerage account balance and donate it to a Charitable Lead Trust (CLT). The CLT would be set up for a 10 year period only. During that time, your Donor-Advised Fund (DAF) would accept annual “lead” gifts from the CLT at 5% of the initial CLT balance—in this case, approximately $50,000. At the end of the 10-year term, the CLT balance would be returned to you tax-free. You could continue to donate to your 2 favorite charities; your DAF would just act as an intermediary of sorts. This would enable you to maintain control over your lead gifts and even let them accumulate over time.

Tom: OK, I’m tracking. So, I imagine there’s a tax deduction for the charitable contribution, right?

Me: Yes. And because interest rates are low, that deduction is sizable.

Tom: Even though I get the money back?… Well, provided that my investment returns do better than the payout I make each year, I’ll get it back—and maybe more, right?

Me: Correct. The tax calculation is based on a rate that is currently much lower than your 5% CLT distribution rate. So, even though you could have a balance left at the end of the CLT term, there is still a present-value tax deduction that approximates 50% of the amount you contribute to the CLT. That rate changes around the 20th of each month but you can use the lowest rate from the preceding 2 months if the rate ticks up as it has been recently…

So, in short, you would be able to offset all of your income tax liability from the IRA conversion. As an aside, this would have to occur over a 2-year period because the deduction could be no more than 30% of your total Adjusted Gross Income in any one year. Then, as long as you could achieve better than a 5% annual after-tax return in the CLT (to offset your Lead payments), you would receive all of your money back at the end of the 10-year term and, in the meantime, your Roth will have been growing tax-free for the next 10 years.


As one of approximately 1,800 attorneys who are also Certified Financial Planners™, Chris Hynes’ education, training and experience furnish him with a unique perspective on complex financial structures, issues and products. Since his admission to the Massachusetts Bar in 1995, Chris has provided estate planning, insurance planning, financial and tax counsel to hundreds of individuals, businesses and non-profit entities.

Learn more about Chris Hynes at Advisor to the Advisors.