There’s a tax bill attached to each traditional individual retirement arrangement (IRA) and 401(k), and Congress recently tried to accelerate and increase that tax bill.
That’s why, following enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, many IRA and 401(k) owners need to revamp their estate planning strategies.
As I’ve reported, the SECURE Act ends the Stretch IRA. When an IRA or other retirement plan is inherited, most of the time the beneficiaries must distribute the entire account within 10 years. There are exceptions for a surviving spouse, minor children, a disabled beneficiary and a few others. But in most cases, the ability to make the tax deferral of an inherited account last more than 10 years is eliminated.
The cost of this change to your heirs is shown in the chart nearby. The upper line in the chart shows the after-tax value of the IRA under the old law, and the lower line shows the after-tax value under the SECURE Act.
In each case, the IRA has an initial value of $1 million, and the beneficiary spends an amount equal to the annual required minimum distributions under the old law. The other details, such as the investment return and tax rate, are the same for each scenario. You can see that after 2019, a beneficiary receives less after- tax value from an inherited IRA than a beneficiary would have before 2020.
Fortunately, there are alternatives that avoid the debilitating effects of the SECURE Act. They can deliver your beneficiaries after-tax results similar to or even better than those the beneficiaries would have garnered before the SECURE Act.
I’ll cover two strategies in detail this month and two more next month. These strategies are for retirement account owners whose primary goal is to leave their IRA balances for children or other loved ones and prefer the beneficiaries don’t spend the account shortly after inheriting it.
The strategies we review this month show how combining an IRA with life insurance can increase the after-tax legacy you leave. There are several advantages to converting a retirement account into a life insurance benefit.
The life insurance payout received by your beneficiaries is income-tax free. When a traditional IRA or 401(k) is inherited, the beneficiaries pay income taxes on the distributions. The amount your loved ones will inherit with life insurance doesn’t fluctuate with the markets. It is fixed and, with some types of life insurance, might increase.
You and your family might have lifetime tax-free access to part of the policy’s value through loans. The loans don’t have to be repaid but will reduce the final life insurance benefit and might be interest free.
Here’s one example of how to enhance your IRA legacy using life insurance. Suppose you are 64, in good health and have a $500,000 traditional IRA. You are in the 28% effective tax bracket. You roll over the IRA to a special qualified account with the insurer.
Each of the first five years you transfer $105,732 from the account to pay the premiums on a Max-Funded Indexed Universal Life policy after paying income taxes on the distribution. The policy has a benefit of $1,182,368 payable to the beneficiaries you name.
After the first year, you can arrange a loan secured by the cash value of the policy. You take a loan of about $29,600 each year to pay the taxes on the amount transferred from the account to pay the premiums.
After five years, the policy is paid up and the account is empty. You won’t have to take required minimum distributions from an IRA in the future. You also have
no out-of-pocket cost for converting the IRA into life insurance. The loans used to pay the taxes eventually are subtracted from the policy benefit. You also might be able to add a longterm care benefit for you to the policy.
You’ve turned a $500,000 traditional IRA into a life insurance benefit of more than $1 million. In addition, the policy will have a cash value account that can be tapped tax-free during your lifetime. The cash value would be more than $300,000 after 10 years and $600,000 after 20 years.
All this value is outside of your taxable estate, while an IRA would have been part of your taxable estate. Your beneficiaries receive the life insurance benefits free of income taxes, whereas they would inherit only the after-tax value of a traditional IRA.
You can have the benefit paid directly to them. Or it can be paid to a trust, which controls how the money is distributed to them.
Let’s look at a second strategy. Suppose you are married, and you’re both 71 and in good health. You have a $1 million IRA. You have other income and assets to fund your retirement and hope to leave most of the IRA to your children and grandchildren. You don’t look forward to beginning required minimum distributions (RMDs) and are concerned the children and grandchildren will spend the IRA too rapidly after inheriting it.
You can set up a family dynasty trust that can benefit your grandchildren, your children or both. You fund the trust with RMDs from the IRA. Your first RMD is over $36,000 and you’ll net over $27,000 after income taxes.
You create a trust that buys a permanent life insurance policy payable to the trust. You make a gift to the trust each year equal to the after-tax amount of the RMDs. This gift should avoid gift taxes because of the annual gift tax exclusion ($15,000 in 2020) and the lifetime estate and gift tax exemption. If the trust buys a joint and survivor life insurance policy covering both you and your spouse (usually the way to maximize the permanent life insurance benefit for the premium dollar), the policy will have a benefit of almost $1.4 million.
After both spouses pass away, the life insurance benefit is paid to the trust. The trust invests and distributes the money according to the terms you set in the trust agreement. It can be paid out to the grandchildren over the years, used to pay for specific needs, held until they reach certain ages or whatever other distribution plan you want.
Remember, the insurance benefit is tax-free to the trust. Instead of inheriting the after-tax value of a $1 million IRA, the grandchildren’s trust receives almost $1.4 million tax free. Plus, the trust substantially reduces the risk the money will be poorly invested or spent rapidly or frivolously. There are other ways an IRA can be converted into a tax-free life insurance benefit. These are just two examples.
I learned about them from David Phillips of Phillips Financial Services. You can learn more details about these and other strategies by ordering David’s free report, The Bombshell Battle Plan: How to Defend Against the IRS’ Secret Weapon and the related report Gift for Life. The reports are available for free by calling 888-892-1102.