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Is Your IRA Insured?

Quite a few of our clients have IRAs and retirement plans that they will not need to support their lifestyle through retirement.  For many, we look at ways to increase the assets while reducing the negative tax impact on passing these assets to children or grandchildren.  There are some amazing results that can be achieved by thinking through planning alternatives in advance.  

Unfortunately, many people don’t realize that retirement plan assets are among the worst assets to die with. They literally can be taxed three times if you are not careful.  

When using IRAs, most parents plan on dying with a significant amount of their retirement benefits passing to their children, in or out of trust.  With this goal in mind, planning for retirement assets is important and must be approached strategically.  Let’s look at a few examples.

Simply Leaving the IRA to Children at Death  

Let’s first assume that Mom and Dad pass away, leaving a $1,500,000 IRA to their children, out of trust.  The $1,500,000 is subject to income taxes when withdrawn from the IRA, and a direct bequest to the children is counted as a taxable distribution.  If estate taxes were paid, the children may receive an itemized deduction against the income taxes, but there is nevertheless a potentially large tax burden.  

While the children may choose to take payments over their lifetimes, it is also possible that they will decide to withdraw the money, pay the income taxes, and use the funds for personal purposes.  The end result is that they will wind up with considerably less than intended (or possible).  

An Insured Alternative  

Assume that the parents want to maximize the amount of property left to their children and know that they will never spend all of their IRA funds.  Further assume that the IRA earns a 4% before-tax return, or $40,000 per year, that Mom and Dad are destined to pass away 10 years later, when the IRA will have grown to $1,500,000.   

Let’s also assume that the parents have a taxable income, are in a 28% tax bracket, and decide to withdraw the annual $40,000 of income instead of leaving it in the IRA. After paying taxes they will be left with $28,800 per year. If they then choose to spend that $28,800 for premiums on a life insurance policy, they might be able to get a death benefit of $800,000 (amount assumed for illustration purposes). If this insurance policy is owned and held by an irrevocable life insurance trust for the benefit of their children and subsequent generations, outstanding results can be achieved. 

Here’s what happens:

If the income accumulated for 10 years, with no required minimum distributions and the parents died without the insurance, the heirs would receive $1,500,000 before tax. If withdrawn by two children at an assumed 35% tax rate, the total inheritance would be $975,000, so each child would receive $487,500.

If the income does not accumulate, but instead is spent on insurance premiums, the IRA remains at $1,000,000.  At a 35% tax rate, the children will have $650,000 left to split between them.

However, the children’s total economic benefit includes not only the IRA proceeds, but also the $800,000 in life insurance.  Because the insurance is owned by an irrevocable trust, the insurance proceeds pass to them free of both income and estate taxes.

With the $650,000 and $800,000 the children have a net benefit of $1,450,000 or $725,000 each instead of $487,500 – a much better financial result.

If estate taxes are an issue, each dollar of income taxes paid by the parents on withdrawal is a reduction in the taxable estate and reduces the estate taxes by an estimated 50 cents. So the effective income tax rate on the withdrawals becomes 14% instead of 28%.

The parents have not been forced to sacrifice to achieve these results because they did not need or intend to use all of their IRA proceeds anyway.  

This is just one of several alternatives you may want to consider. Remember also that much simplification has been done here for ease of illustration.

But keep in mind insurance in mind when planning with an IRA. It is often the best way to solve the many tax problems associated with IRA ownership as well as preserve funds for the next generation.

If this type of planning is interesting to you click here to have our office call to set up a time to discuss this with you.

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The information contained on this web page is general by its nature. For that reason, no one should take any action based on the information contained in this webpage until having consulted a competent professional advisor or advisors. Nothing contained in this web page was intended or written to be used, can be used by any taxpayer, or may be relied upon or used by any taxpayer for the purposes of avoiding penalties under the Internal Revenue Code. No information contained on this webpage relating to any federal tax matter may be used by any person to support the promotion or marketing or to recommend any federal tax matter. Taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor with respect to any federal tax transaction or matter described on this webpage.



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