The Dilemma

Many people who have been successful in saving for retirement have established a  large enough nest-egg to be able to create a legacy for their children, grandchildren and favorite charities, leaving them to wonder how to best leverage their qualified or tax advantaged retirement plans.  A common question is whether IRA owners should take larger withdrawals and pay income taxes now, or whether they should take out as little as possible during their lifetime, leaving a likely income tax burden for their heirs and beneficiaries. 

Tax Saving Alternatives for IRAs

If an IRA owner is looking to protect loved ones and to maximize wealth transfer, he/she can utilize life insurance to minimize the tax burden that inheriting an IRA may impose on a beneficiary.  With two different strategies identified below, investors can maximize the after-tax value of their IRA or even eliminate taxes paid on the IRA inheritance. 

IRA Required Minimum Distributions

Proper consideration should be given to IRA distributions and the resulting tax  implications as these can affect the amount a beneficiary may inherit upon IRA owner’s death.

• Beginning at age 70½, the IRA owner is required to withdraw an increasing percentage of an IRA’s account value each year until the IRA is exhausted – “Required Minimum Distribution (RMD)”.

• Eventually RMDs will be larger than the expected annual interest growth. When that happens, the IRA may well be at its peak value, typically between ages 85 and 90.
• When an IRA owner dies, the beneficiary must include taxable amounts received in his or her gross income.
• Because IRAs are frequently transferred at or near their peak value, IRA inheritances are often taxed at higher income tax rates. It is not uncommon for retirees to die sometime between their 75th and 95th birthday. When that happens IRAs are often passed to the next generation at-or-near peak values. Because these IRA inheritances are fully taxable to the beneficiaries as ordinary income, they are often taxed at very high rates. 

The two solutions described here help reduce or eliminate the taxes imposed on an IRA beneficiary, thus maximizing the value of the inheritance. 

“Current” Scenario It is not uncommon for an IRA owner to reinvest his/her mandated IRA RMDs while using other portfolio assets for retirement and living expenses. This leaves the majority of the IRA balance intact and transferred, along with the tax liability, to the beneficiary at the owner’s death.  

Innovative Solutions for IRA Wealth Transfer

• At IRA owner’s death, bulk of IRA is intact and paid to beneficiary
• Income taxes are due on the IRA amounts received by the beneficiary
• If a beneficiary is in his/her 50’s and 60’s (often the case) at IRA owner’s death, earning his/her highest career income, he/she will pay taxes in a high income tax rate.
• The addition of IRA inheritance to beneficiary’s existing taxable income could push the recipient into a higher tax bracket.
• This can result in excessive income taxes to the beneficiary, reducing the net value of his or her inheritance.
• The constraints of maintaining the asset’s tax deferred status may not meet the beneficiary’s existing financial and retirement planning needs. 

Solution 1: Offset IRA Beneficiary Income Taxes

Use IRA RMDs to help pay for a life insurance policy equal to income tax due from beneficiary at time of inheritance. Life insurance benefit pays income tax due and full value of the IRA is maintained. 

Results

Beneficiary receives life insurance death benefits income tax-free and can use those funds to pay the taxes due on IRA inheritance. 

• Now, beneficiary owns the IRA funds and all of the income taxes have been paid. Beneficiary has discretion to invest/use full amount of IRA funds without penalty taxes or required distributions. 

Solution 2: Eliminate IRA Beneficiary Income Taxes

By creatively incorporating a charity and the IRA’s RMDs to fund a life insurance policy for beneficiaries in a similar but slightly different manner as Solution #1, the federal taxes on the distribution of an IRA can be completely eliminated.  

Part 1

Name a tax-exempt charity as the IRA beneficiary. With the charity’s tax exempt status, no taxes will be due on the inherited IRA funds. 

Part 2

This solution can be taken a step further to incorporate a loved one as a beneficiary.  Use IRA RMDs to help pay for a life insurance policy equal to the estimated peak value of the IRA. Loved ones can be named as beneficiary of the life insurance policy and would receive the life insurance death benefits income tax-free under the current tax law. 

Results

Total wealth transferred ($1,000,000) is more than three times the amount of net after-tax IRA inheritance ($325,000), and the income taxes have been eliminated.

• Beneficiary of life insurance policy receives full death benefit (equal to estimated IRA value) income tax-free6.
• Charitable IRA beneficiary receives full value of IRA income tax-free (at IRA owner’s death)
• Zero taxes are paid on either the IRA or the life insurance policy 

Contact Us

For answers to your questions about IRA’s and Life Insurance as a strategy to reduce tax burdens, call Jerry Linville, 281.794.3783.

Dean & Draper is a Trusted Choice insurance agency representing over 200 insurance companies. For over 35 years we have offered a trusted freedom of choice to our clients. Contact us.

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