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IRA Planning for the Next Generation
Individual retirement accounts and qualified retirement plans (401k, 403b, and 457 plans) can be excellent tools for saving for retirement and building wealth. But they’re not very efficient when it’s time to pass on these assets to your children or grandchildren.
The first beneficiary of your retirement assets is Uncle Sam. His share comes under a tax that is referred to in the Internal Revenue code as income in respect of a decedent. In addition, the federal estate tax may impose a tax on all the property you own at your death (including retirement plan assets) if your estate is in excess of $3.5 million (2009). This tax must be paid from your estate.
One technique used by many families to recover the money lost to taxes is the purchase of life insurance by an irrevocable life insurance trust (ILIT). Here’s how it works:
·The owner of a large IRA (potentially subject to estate tax) begins taking withdrawals or required minimum distributions. Please note that these distributions are subject to ordinary income tax and, if made prior to age 59 and six months may also be subject to a 10 percent federal income tax penalty.
·The net amount withdrawn (after income taxes have been withheld or paid) is gifted to an irrevocable life insurance trust, which in turn purchases a survivorship (frequently referred to as second-to-die) life insurance policy on the IRA owner and spouse.
·Upon the death of the IRA owner, the surviving spouse elects a rollover to his/her own IRA. (No taxes are due at this time).
·The surviving spouse continues to take either elective withdrawals or required minimum distributions.
·The surviving spouse also uses part or all of the IRA distributions to fund the ILIT with distributions received from the IRA. The “Rule of Two” holds that a policy should always have at least two contingent beneficiaries. If the beneficiary dies before the insured, the proceeds may be paid back to the insured’s estate. Following the rule will help to avoid this problem.
·Upon the death of the spouse, the remaining IRA balance is placed in a separate IRA for each beneficiary. At this time, the IRAs are potentially subject to income and estate taxes. And, each beneficiary must take required minimum distributions which are subject to ordinary income tax.
·In most cases, ILIT beneficiaries (the same family members named as retirement account beneficiaries) receive the life insurance death benefit free of income and estate tax. The life insurance death benefit may provide liquidity for any estate taxes, leaving the remaining separate IRA accounts intact to accumulate tax-deferred.
A few important reminders:
Life insurance has long been a staple in basic estate planning. Life insurance can provide an income tax-free death benefit far in excess of the premiums paid. However, much of the life insurance proceeds can be wasted if the ownership and beneficiary designations are not properly structured. Any gift of life insurance to a third party (except to your spouse) may carry with it gift tax consequences. Additionally, if you fail to survive your gift by three years, the policy will be brought back into your estate. Because of these pitfalls, you should always seek tax and legal advice prior to any transfer.
This type of planning is most appropriate for those individuals who do not need required minimum distributions or IRA income to meet their living expenses. And you should always seek tax and legal advice prior to making withdrawals or making transfers.
When planned and executed properly, this may be a much better way to maximize the potential value of your retirement plan assets for those you love.
Chad Carlson, CFP® is a CERTIFIED FINANCIAL PLANNER™ practitioner with Delta Trust Investments, Inc. Chad may be reached at (501) 975-4010 or ccarlson@delta-trust.com .
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