Protect the IRA Value

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protecting nest eggLife insurance

Earlier, we showed how a large IRA in a significant estate can be burdened with an 86% combined tax (federal income tax, state income tax and state estate tax). A common way to offset these taxes is by using life insurance. Since these taxes are due or become liabilities at death and life insurance pays at death, the tax liability and the life insurance death benefit are perfectly matched in time.

Note that when spouses inherit IRAs, they avoid the estate tax on the accounts because of the unlimited marital deduction. However, they will still have to pay income tax on distributions that must begin when they reach age 70½ and there may still be estate taxes due at death of the survivor.

Life insurance is the most efficient way to protect a large IRA. Non-IRA assets should be used first to buy the insurance. However, even if you need to remove money from the IRA to pay the premiums, the life insurance scenario may still be beneficial as in the example above. And if the IRA owner is over 70½, he or she needs to begin Required Minimum Distributions (RMD). So why not leverage the distribution and buy life insurance?

An irrevocable life insurance trust should own the policy. Generally, you never want to own life insurance in your own name. Here’s why. At death, the entire death benefit is included as an estate asset. For example, if you have paid $100,000 in premiums to own a life policy that pays $1 million at death, the $1 million is included in your estate, and if your estate is large enough and taxable, IRS can levy a 46% estate tax on the death benefit. However, this is easily avoided by owning the policy outside of your estate.

You use the $13,000 annual gift exclusion as follows:

  1. You establish an irrevocable life insurance trust (ILIT)—any estate planning attorney can draw this document.
  2. You appoint a trustee of the trust (a trusted family member or advisor).
  3. You decide on the beneficiaries of the trust (e.g. your two children).
  4. You gift to the trust the amount needed to pay the annual life insurance premium. Let’s assume its $20,000. You gift to the trust $20,000, $10,000 on behalf of each of the two beneficiaries (gifts of $12,000 per donee per year are not subject to gift taxes so you’re clear).
  5. The trustee takes the cash and pays the premium, and the owner of the policy is the ILIT. The policy is out of your estate and will never be subject to estate taxes.

This will keep the death proceeds out of the IRA owner’s estate. When the owner dies, the life insurance proceeds will be used to pay the estate tax (or any way that the beneficiaries desire), thus the beneficiaries will not have to invade the IRA to pay taxes. The beneficiaries will then be able to stretch out the IRA withdrawals and the income tax over a period of many years.

Example

Bill has a $1 million IRA. The only other asset is a $500,000 home that he owns with his wife, Linda. Together, they have a 42-year-old son, Ted. 

Bill should leave his IRA to Ted. Hence when Bill dies, Ted will receive the $1 million estate tax-free ($2 million exemption in 2006). Ted will then be able to stretch out the distributions over his lifetime, thereby adding decades of tax deferred growth to the IRA.

Linda, however, also needs $1 million to support herself if Bill dies.

Bill uses money from the IRA to buy a $1 million life insurance policy on his life and names Linda the beneficiary. There will be no estate taxes because of the unlimited marital deduction. Furthermore, Linda will get the $1 million income tax free rather than a tax-riddled IRA.

When Bill dies, Ted will receive whatever is left in the IRA. Linda will have $1 million to spend as she wishes without worrying about taxes or RMD regulations.

However, suppose Bill likes the idea that a Roth IRA passes income-tax-free to beneficiaries, but he doesn’t have the $400,000 to pay the tax on a conversion?

Bill could buy a $1 million life insurance policy and name Linda the beneficiary on the policy as well as on the IRA.

When Bill dies, Linda receives the life insurance proceeds and the IRA. She rolls the IRA into her IRA. As long as her income is not over $100,000, she can convert the $1 million rollover to a Roth IRA. She’ll use $400,000 from the life insurance proceeds to pay the income tax.

Linda’s Roth IRA will not be subjected to RMD, she’ll never have to withdraw money, and any funds that she does take out are income tax-free. When she dies, her heirs will receive the Roth income tax free. But, if her account grows so much that there could be an estate tax problem, Linda can use a trust to buy a life insurance policy to pay potential taxes.

Linda’s beneficiaries will receive the death proceeds income and estate tax free, and use the funds to pay the estate tax on Linda’s Roth.

As you see, life insurance creates liquidity and flexibility for tax and estate planning.

Example

Ed and Ann are married; both are age 63, and they have a $1.5 million total net worth. Part of that is Ed’s $1 million IRA with Ann named as the primary beneficiary. They make plans in 2005 using that year’s tax rates. They have planned that Ann will use that money to support herself when Ed dies. But what they haven’t realized is that every dollar of this income will be taxed as ordinary income at Ann’s current tax bracket.

An alternative strategy could be for Ed to leave his IRA to his 35-year-old daughter, Jane. The entire $1 million will pass estate tax free to her when Ed dies because of the credit shelter amount (see appendix 2). Then she can stretch the taxable distributions out over her lifetime (48.5 years).

To provide for Ann, Ed would purchase a $1 million life insurance policy on his life and name her as the beneficiary. He could pay the premiums with money in his non-IRA accounts or take taxable distributions from the IRA. When he dies, Ann will receive the $1 million death benefit and estate (unlimited marital deduction) income tax-free, and be able to invest the money any way she pleases.

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