Many high net worth clients will transfer wealth to the next generation from their individual retirement accounts. When clients learn they have overfunded their retirement accounts, they realize that all or part of those accounts will be left to their heirs. Preserving and protecting these hard-earned assets is the main goal.
A strategy called IRA maximization is designed to help clients reposition this portion of their assets, known as “leave on” money, into a more tax-efficient vehicle at death. When done correctly, distributions from an IRA fund a life insurance policy, helping to manage the tax liability and maximize the amount that passes to beneficiaries, free of income and estate taxes.
How It Works
Whether the IRA owner wants to “leave on” part or all of their retirement funds, repositioning retirement assets into a life insurance policy should be a consideration. Unlike a traditional IRA or a 401(k), where every dollar is taxed, with life insurance the cash values can be accessed on a more favorable tax basis. The death benefit is typically income tax free.
Today, the estate and gift tax exemption is $11.58 million per individual or $23.16 million per couple. This exemption is due to “sunset” no later than 2026. The exclusionary amount in 2026, by all indications, will be $5 million for an individual and $10 million for a couple.
Establishing an irrevocable life insurance trust can remove the assets from a taxable estate. The owner makes annual distributions from the IRA, which pays the taxes on the withdrawals, and funds the life insurance inside the ILIT.
Repositioning assets into a favorable tax saving vehicle means clients can leave more to their beneficiaries. However, an ILIT is not necessary if clients do not have a taxable estate. On the other hand, if the heir is receiving money directly from the IRA, the income tax from the income respect to a decedent erodes much of the wealth. The funds received from the life insurance policy are tax free.
An option for the high net worth individual is to begin withdrawing taxable distributions at age 72 or earlier from their traditional IRA, 401(k), etc. to fund a life insurance policy. This strategy is effective for managing forced distributions and could reduce the IRD and potential estate tax burden while simultaneously increasing the amount of wealth transferred to beneficiaries.
Evidence of insurability is needed to qualify.
Must pay taxes on IRA withdrawals.
Design a policy to remain in force at death.
If married, utilization of a survivorship policy.
Creation of an ILIT involves legal work.
ILIT applies for life insurance.
ILIT is generally used if the client has a taxable estate; if not, ILIT is not necessary.
The portion of clients’ assets that would be repositioned into a life insurance policy must not be needed for retirement income in their retirement plan.
High net worth clients find this IRA maximization strategy appealing for many reasons. Offsetting taxes for the heirs is a motivator. When clients enjoy good health, the leveraging of the distributions far outweighs the taxes that they must pay on the premiums. When clients want to leave their IRA to a charity, they can completely eliminate the taxes by leaving the entire IRA to the charity and then purchase a life insurance policy equal to the projected IRA value at death for their heirs. Some clients may want to enhance the legacy and protect their portfolio by adding a long term care rider to the policy.
Now that the SECURE Act has eliminated the ability to stretch an IRA for the next generation, in most instances, clients may want to put restraints on the money left to “spendthrift” or troubled heirs. By using life insurance, clients can create a multigenerational legacy plan. If the owner has a spouse who is much younger or not well-versed in financial matters, the life insurance can provide the liquidity to pay the taxes on the inherited IRA, allowing for Roth IRA conversion. Now, the spouse can take as little or much as needed annually without having to pay taxes. Also, the growth that is now in the inherited Roth IRA grows tax free.
Benefits Of Using Life Insurance
Increase legacy to heirs and charities by:
Protect the portfolio.
Spousal Roth IRA.
Many recent changes introduced by the SECURE Act are widely unknown to our clients. The legacies that could be stretched over the heir’s lifetime has been reduced to 10 years in most cases. Please be sure to discuss this in conversations with your clients.
Laura Coleman is a business development specialist with Truist Life Insurance Services. Laura may be contacted at [email protected].