Building a legacy with IRA strategies using life insurance
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 concern is whether financially successful retirees should make their children the beneficiaries of their IRA, leaving a likely income tax burden.
Over the next 25 years, an estimated $68 trillion will change hands from aging households to their heirs and charity.1
What will an IRA be worth when transferred?
If you plan to pass an unneeded IRA to a beneficiary, proper consideration should be given to IRA required minimum distributions and the resulting effect these can have on the amount a beneficiary may inherit upon IRA owner’s death.
- Beginning at age 72, 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 80 and 90, as depicted in the chart below.2
- 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, the higher values can cause increased taxable income for the beneficiaries.
It is not uncommon for retirees to die sometime between their 75th and 95th birthday. As the graph below depicts, 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 may be taxed at very high rates.
Tax saving alternatives using life insurance
If an IRA owner is looking to protect loved ones and to help maximize wealth transfer, he/she can utilize life insurance to help minimize the tax burden that inheriting an IRA may impose on a beneficiary. With two different strategies identified, individuals can help maximize the after-tax value of their inheritance or even eliminate taxes paid on the IRA inheritance.3
Alternative 1: Offset IRA beneficiary income taxes
Options include the purchase of a life insurance policy equal to the anticipated income tax due from the beneficiary at the projected time of inheritance. Life insurance death benefits may be used to pay the income tax due, maintaining the full value of the IRA even after taxes are paid.
Alternative 2: Eliminate IRA beneficiary income taxes
By naming a charity as the IRA beneficiary, and funding a life insurance policy with your children as the beneficiaries, you can leave a significant legacy to both your children and your charities, while the federal income taxes on your children’s IRA inheritance can be completely eliminated.
The chart below provides a hypothetical comparison of what IRA distributions look like on the same IRA account before (“Current” bar) and after the two solutions were used (“Tax Offset” and “Tax Elimination” bars).
These strategies can help maximize the amount of money beneficiaries receive and provide greater flexibility in how the assets are ultimately put to use.
After-tax benefit amounts
Comparison of wealth transfer alternatives for a $500K IRA
1 Cerulli Associates, U.S. High-Net-Worth and Ultra-High-Net-Worth Markets 2018: Shifting Demographics of Private Wealth. 2018.
2 Depends on life expectancy factors, the assumed annual rate of return and additional deposits or withdrawals made.
3 American General Life Insurance Company and their distributors and representatives may not give tax, accounting or legal advice. Any tax statements in this material are not intended to suggest the avoidance of U.S. federal, state or local tax penalties. Such discussions generally are based upon the company’s understanding of current tax rules and interpretations. Tax laws are subject to legislative modification, and while many such modifications will have only a prospective application, it is important to recognize that a change could have retroactive effect as well. Individuals should seek the advice of an independent tax advisor or attorney for more complete information concerning their particular circumstances and any tax statements made in this material.