Juggling to Trim a Wealthy Executive's Taxes

Kimberly Weisal for the Wall St Journal writes: In many ways, the client's situation was enviable: In his mid-50s, he had retired from a financial-services company with a lump-sum pension and other cash payments exceeding $3 million. A new position on another company's board of directors would provide $200,000 a year in the future.

But it posed a challenge for his adviser, Chuck Bean. "We had to ask, 'What can we do to mitigate taxes?'" said Mr. Bean, president and principal of Westwood, Massachusetts-based Heritage Financial Services, FMBI +0.22%First Midwest BancorpU.S.: Nasdaq ^$18.35 +0.04+0.22% Nov. 29, 2013 9:44 am Volume (Delayed 15m) : 0 P/E Ratio 18.49Market Cap $1.37 Billion Dividend Yield 1.53% Rev. per Employee $265,10711/29/13 Juggling to Trim a Wealthy Exe...More quote details and news »FMBI inYour ValueYour Change Short position which manages $825 million for 300 families.

Mr. Bean had been the executive's adviser for 10 years, and he calculated that the client's blended federal tax rate would be about 35%--plus a blended state tax rate of 13% in California, where the client and his wife planned to move.

The adviser first tackled the pension plan, which had a qualified and nonqualified component. Mr. Bean recommended rolling a $1.5 million lump-sum payment from the qualified portion of the plan into an IRA. The nonqualified portion was a cash-balance plan that would pay the client about $2 million over 18 months, and the adviser said the client had no choice but to take receipt of that money.

The new board position presented another piece of the puzzle because the company offered a nonqualified deferred-compensation plan. Mr. Bean recommended deferring all of the annual earnings as a director until 2015, when payments from the cash-balance portion of pension plan would be fully paid out.

Then Mr. Bean looked to reduce the client's taxes after 2015. Serving three years as a director would provide the track record necessary to set up and fund a single-person defined-benefit pension plan, so he recommended the client work with his accountant to register as a sole proprietor and file a Schedule C for his board income. Then they can choose a third-party administrator to set up and administer the single-person plan, with Mr. Bean's firm managing the assets in it.

For the next 10 years, according to the plan, most income from the directorship will go into this plan, while the client lives off his nonretirement assets. During these years, the client's taxable income will be relatively low, so Mr. Bean will use that opportunity to gradually convert the client's large IRA holdings into a Roth IRA. "We'll get it all out of the IRA and into a Roth by age 70 1/2," the adviser said.

He estimates the client will pay a blended federal rate on those conversions of 25%. At age 70 1/2, the client will have converted about $2.3 million into the Roth, which will be growing tax-free with no required distributions. At that stage, the client will live on the required minimum distributions from his single-person pension plan and payments from the deferred compensation plan.

The client was happy to have a strategy that provides adequate retirement income and tax efficiency, while also creating a sizable Roth account to grow tax-free. But there was one idea the client wouldn't accept: Mr. Bean's recommendation that the couple postpone their move to California, so they could collect the nonqualified lump-sum distributions at their home state's lower, 5.25% state income-tax rate.

In that case, lifestyle choices trumped the chance to save even more on taxes.

"The client and his wife can't wait to get back to Northern California," said Mr. Bean. "They love wine country and they have family there."