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That is not a bet you should make. For even if the tax goes away, the income tax “step-up-in-basis” provision for the most part goes away too. And beneficiaries could use life insurance to pay the capital gains tax on appreciated assets rather than liquidate the IRA. They’ll then have the opportunity to stretch the distributions out and delay paying the associated income tax on the withdrawals.
Therefore, it’s better to plan on the probability that the tax will remain because that’s a more conservative outlook. The worst scenario might be that there are no taxes to pay, and the beneficiaries inherit more tax-free money.
If the parents want to do the stretch IRA for their beneficiaries, then leaving a large IRA increases the estate size, and they need life insurance to pay the estate tax. If they don’t care about the stretch (i.e. they have plenty of other assets to leave the kids or don’t care about the kids), then they can buy life insurance with their retirement money.
Example:
In this example, the IRA owner is age 60. He has two choices: allow his IRA to continue to grow or do planning. His estate is subject to the top estate tax bracket in 2006 and he is using current rates for his planning. Assume that the money grows at a hypothetical 8% annually and that he is in good health and insurable. He has a $100,000 IRA and dies 10 years from today. Here’s what happened under the two scenarios of do nothing or do planning.
Table 4.4: Protect an IRA With Life Insurance
| Keep IRA/Do
No planning |
Using Life
Insurance |
|
|---|---|---|
| ($100,000) IRA
Balance in 10 years (8%) |
$215,893 | $128,973 |
| Estate tax (46%) | ($99,311) | ($59,328) |
| Beneficiary gets | $116,582 | $69,645 |
| 33% income tax | ($38,472) | ($22,983) |
| Net IRA
proceeds |
$78,110 | $46,662 |
| Life insurance
proceeds* |
$100,000 | |
| Estate tax (46%) | ||
| Net life insurance
proceeds |
$100,000 | |
| Net to beneficiary | $78,110 | $146,662 |
*Manulife UL, 60-year-old non-smoker, $4,234.00 annual premium for 10 years. Assume life policy is owned outside of the estate. Taxes are combined federal and state. Note that the purchase of life insurance involves fees, commissions and taxes and not all people are insurable.
In the illustration above, the beneficiaries would lose $99,311 to estate taxes if the IRA owner keeps the IRA and dies in 10 years. The inheritance will be further diminished by the beneficiaries’ personal income tax rates. An alternative would be to start taking IRA distributions at age 60, pay the income tax, and buy a life insurance policy with the after-tax distribution.
The IRA owner could withdraw $6,000 per year and purchase a $100,000 life insurance policy. After 10 years, the policy would be paid up to age 100.
If the IRA owner dies in year 10, his heirs would net $46,662 from the IRA and $100,000 from the life insurance. This transfer could save almost $70,000 on a $100,000 IRA.
