Many high-net-worth individuals are transferring wealth to the next generation from their Individual Retirement Accounts (IRAs). For those who have overfunded these accounts, they may realize that all or part of the balance will be left to their heirs and that taxes could reduce the amount significantly. Life insurance may be a tax-advantaged way to fund this “gap” caused by taxes and provide added death benefit protection to heirs. Since the assets in these accounts are usually all pre-taxed, the balance is generally subject to ordinary income tax when passed on to beneficiaries. Preserving and protecting these hard-earned assets for the next generation may be possible with some advance planning.
IRA Maximization is a strategy designed to help individuals 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 can fund a life insurance policy, helping to manage tax liability and potentially maximize the amount that passes to beneficiaries, possibly free of income and estate taxes. This approach may work well for those who want both death benefit protection and to maximize their IRA legacy.
How it works
Whether individuals want to “leave on” part or all of their retirement funds, repositioning retirement assets into a life insurance policy is worth considering. Unlike a traditional IRA or 401(k), where every dollar is taxed, life insurance cash values can often be accessed on a more favorable tax basis. The death benefit is typically income tax-free.
Using an Irrevocable Life Insurance Trust (ILIT) may remove the assets from a taxable estate. The owner makes annual distributions from the IRA, which pay the taxes on the withdrawals, and funds the life insurance inside the ILIT. Repositioning assets into a favorable tax-saving vehicle can mean leaving more to beneficiaries. However, an ILIT is not necessary if you do not have a taxable estate.
If the heir receives money directly from the IRA, the income tax from the income in respect to a decedent (IRD) can reduce much of the wealth. Funds received from the life insurance policy are tax-free. One option is to begin withdrawing taxable distributions at age 72 or earlier from your traditional IRA, 401(k), etc., to fund a life insurance policy. This strategy may help manage required distributions and could reduce IRD and potential estate tax burdens while increasing the wealth transferred to beneficiaries.
According to the IRS, the estate and gift tax exemption is currently $11.58 million per individual or $23.16 million per couple. This exemption is due to “sunset” no later than 2026. The exclusion amount in 2026 is expected to be $5 million for an individual and $10 million for a couple.
Considerations
- Need for death benefit protection from life insurance
- Evidence of insurability is required to qualify
- Taxes must be paid on IRA withdrawals
- Policy should be designed to remain in force at death (if married, consider a survivorship policy)
- Creation of an ILIT involves legal work (generally used if the client has a taxable estate; otherwise, it may not be necessary)
- Portion of assets repositioned into life insurance should not be needed for retirement income
Solution
High-net-worth individuals often find using life insurance for this IRA Maximization strategy appealing for several reasons. Offsetting taxes for heirs is a common motivator. When you’re in good health, protection from the tax-free death benefit may outweigh the taxes paid on IRA distributions used to pay premiums.
If you want to leave your IRA to a charity, you may eliminate taxes by leaving the whole IRA to the charity and purchasing a life insurance policy equal to the projected IRA value at death for your heirs. You might also enhance your legacy and protect your portfolio by adding a long-term care rider to the policy.
While the SECURE Act has limited the ability to stretch an IRA for the next generation in most cases, you may still have options for structuring restraints on money left to “spendthrift” or troubled heirs. With trust planning combined with life insurance, you can create a multigenerational legacy plan.
As a reminder, your spouse has more options when receiving IRA assets, and life insurance can play an important role. For example, life insurance can provide liquidity to pay taxes on the inherited IRA, allowing for a Roth IRA conversion. The spouse can then take as little or as much as needed annually without paying taxes. Additionally, growth in the Roth IRA grows tax-free.
Benefits of using life insurance
Life insurance can provide death benefit protection while increasing legacy to heirs and charities by:
- Offsetting taxes
- Eliminating taxes
- Enhancing legacy
- Protecting the portfolio
- Providing multigenerational legacies
- Offering a spousal Roth IRA
Many recent changes introduced by the SECURE Act are not widely known. The legacies that could be stretched over an heir’s lifetime have been reduced to 10 years in most cases, unless the beneficiary is an “eligible designated beneficiary” (EDB), defined as a surviving spouse, minor child, disabled or chronically ill person, or a person not more than 10 years younger than the deceased qualified plan participant or IRA owner.
