“I already have a pretty big IRA. Can’t I just leave that for my kids?” This was a question posed to us by a man who had a pretty impressive IRA balance. He’d already set it up so the balance would go to his son when he passed away, and as a result, he was wondering if life insurance was really necessary at all. Then, we showed him what that IRA would do to his estate taxes and his son’s inheritance.
IRAs are tax-deferred products after all. Eventually, someone is going to have to pay that tax bill. When you leave behind funds from an IRA or annuity, you’re not just leaving your heirs money. You could also be leaving them a hefty tax bill that goes along with that wealth distribution. Luckily, there is a way to work around this with life insurance.
The Tax Burden for Non-Spousal Beneficiaries
Spousal beneficiaries have a bit more wiggle room when they’re inheriting an IRA or annuity because they can generally treat it as their own. Non-spousal beneficiaries, on the other hand, only have two choices when they inherit a qualified retirement account:
- They can choose to take payments from the account over their life expectancy.
- They can liquidate the account within five years of receipt through regular withdrawals.
In either case, they can’t just leave the money in there to avoid being hit with taxes. They have to remove it eventually. The problem is that these accounts are tax deferred and are often transferred when they’re at their peak.
You want your beneficiaries to be able to inherit your IRA or annuity without inheriting a large tax debt, which is why there are a few life insurance strategies that you can use to work around it. It just takes some advanced planning.
Using Taxable Distributions to Fund a Premium
There are a few options for getting the tax burden off of your heirs while also limiting yours. One is to take care of a small portion of the taxes now to create a source of tax funds that can be used to pay the taxes on the IRA or annuity distributions later.
In either the case of an annuity or an IRA withdrawal, as long as you’re within your withdrawal limits, you can take a portion out and pay the taxes at your standard income tax rate. You can then use the withdrawn funds to purchase a life insurance policy which, when you die, will be worth several times that withdrawn amount.
Using this can cut down the tax burden as well as give your heirs an additional source of funding to pay any taxes on the account. Because life insurance passes on to beneficiaries tax free, they will have a tax-free source of funding to cover any tax burden they may inherit from the IRA or annuity.
This is a strategy that can be best used with permanent insurance. This is because having a permanent policy will allow you to be assured that your beneficiaries will ultimately receive the tax-free death benefit provided by the policy.
Now, while doing this might help your beneficiaries work around their own personal tax burden, one issue they’ll still run into is that the value of that IRA, annuity, or life insurance policy will all be considered part of your estate, which could be heavily taxed if it exceeds $11.2 million. To avoid that risk, sometimes, you may choose to transfer the entire value of your IRAs, annuities, and life insurance policies to an irrevocable life insurance trust (ILIT).
Transferring IRA or Annuity Value to an ILIT
An ILIT is a tax shelter that can protect your assets and preserve their value for heirs. When you’re trying to pass on an IRA or annuity, it can be a great option to incorporate into your strategy. In this case, the ILIT is the entity buying policies on your behalf.
Say, for example, you had an IRA worth $1 million. When you die and pass that IRA on, your beneficiary will have to pay taxes whether he or she withdraws the full amount or chooses to take those withdrawals in increments. So instead of giving your beneficiary the IRA outright, you can liquidate it and turn it into a much larger fund.
Here’s how it works. You initially set up a life insurance trust to benefit a specific person or people. Then, you use your annual IRS gift exclusion amount of $15,000 per individual per year. Using funds from the IRA or annuity, you gift that after-tax amount to the trust in the beneficiary’s name and the trust uses those funds to purchase a permanent life insurance policy. The death benefit of the life insurance policy will far exceed the amounts you gifted.
You can use this strategy two ways. You can keep doing yearly withdrawals and gifting them to the ILIT until you’ve exhausted the account. At that point, you will have a pool of funds that will be worth several times what your IRA was worth to begin with. The funds will not become part of your estate, and the beneficiary won’t have to pay taxes on them.
The other option is that you simply estimate the tax due and use the ILIT as a way to fund the tax bill when the time comes. While this won’t create a huge value jump like a full transfer will do, you will be able to protect your heirs from the taxes on that particular account.
Transferring the value or creating a tax funding pool to manage funds can ensure that your beneficiaries won’t inherit a huge tax burden along with inheriting your IRA or annuity. If this is a strategy that you think could work for you, contact a Howard Kaye advisor at 800-DIE-RICH for more information.
