Creating Legacy By thinking Creatively !

Many of us own qualified plans such as employer sponsored 401k and IRA. Over the years they have contributed to the plans and have created a great amount of wealth.  While creating the wealth they received a tax deduction by making   contributions to the plans which were tax deductible.  Sounds good so far.  

However, there comes a time when the governments gratuitous treatment of qualified plans must end.  Now they want their money, In the form of taxes on the withdrawal of 100% of the money, not just the accumulation, but also the contributions which you received a deduction for (I always wondered why they did not just tax the amount of your contribution when you withdrew them instead of the whole account). 

Many seniors when they get to age 72 find they do not need the money to support their lifestyle but are forced to take the withdrawal (Required Minimum Distributions-RMD) anyways.  Recently, the required minimum withdrawal rules changed, and instead of taking the distribution at 70 ½, the distributions will start at 72.   

The segment of the population that does not need the distribution of the qualified money, have a few options that might end up being more helpful than just taking the distribution, paying the taxes, and then reinvesting the money, only to be taxed on the interest once again.   

LET US TALK LEGACY.  

Option 1:  Take the distribution.  Pay the taxes and re-invest the money once again, only to be taxed.  Upon death the money is distributed to your heirs.  Depending on the inheritance tax laws in effect at the time of your death, you may have federal and state taxes to pay on that asset left to the family. Once again, taxes.  So far, I have counted three taxes:  Federal taxes/state on the distribution.  Federal/state on the invested after-tax reinvestment, and Federal and state taxes on the distribution of the asset to the family.   

Option 2: Take the distribution of the qualified money which is taxable. The net after tax withdrawal is gifted into   the irrevocable trust.  The trust will use the money to buy a “second to die life insurance policy”, on life of the IRA owner (the grantor), and the spouse.    At the death of husband and wife, the policy will pay a tax-free amount to the trust.  This tax-free amount can be distributed tax-free to your beneficiaries at a future date.  

Note:  If this were a qualified account (Like a 401k or IRA), the balance of the account would be considered an inherited IRA if left to other than a spouse. Withdrawals would have to be made within ten years of death.  The withdrawals are taxable.    

If it were left to a spouse, they could continue the account, however, they would pay taxes on the withdrawal of the funds. Also, assuming no marital deduction (if left to other than spouse), there could be a federal/state inheritance tax on the value.  

Option 3:  Set up option 2, however, the balance of the qualified account(IRA), payable to the children, or grandchildren could be used to buy life insurance on the parents’ life, again recycling the RMD’S to create a tax-free legacy for the grandchildren. The distribution could purchase life insurance on the life of their parents, to pay for the life insurance over a ten-year period (inherited IRA’s need to be paid out over ten years). The proceeds of the life insurance would be tax-free to the grandchildren. They would not have to make mandatory distributions from the life insurance, unlike the inherited IRA. The children, who may be the beneficiary of the trust in option 2, would also not have to take mandatory distributions from the life insurance. Consequently, both generations would save a lot of taxes, inherit much more, and have a plan which did not force them to liquidate inherited assets.  

THE NUMBERS:   

Option 1: Take RMD and invest the money 

Assume the IRA was worth $1,000,000 that dad owned:  Assume he takes out the mandatory distribution of $37,000. He paid taxes (35%) and net $24,000 (rounded down). Let us say he invested at 4%. In 20 years, he would have accumulated $743,000. His gain would have been $92,000, which he would pay tax on. His net value of the account would have been $650,000 to leave to his children and grandchildren. After tax, the net ROI would have been 2.81% before federal and state inheritance taxes.  

Option 2:  Take RMD and buy a 2nd to die life insurance policy and put into an irrevocable trust while living (there is no need to wait to age 72 to do this).  

The 2nd to die life insurance policy would be worth $1,000,000. At his and his spouse’s death, the beneficiaries of the trust would receive $1,000,000 tax free. None of the life insurance proceeds would be subjected to inheritance taxes (fed/state), unlike in option 1. The ROI on the death benefit would be the equivalent of a net of 6.56%, or pretax rate of 10.10% on investment, (we are assuming parents paid $24,000 for 20 years, then died). By having the life insurance/trust, he would have left $350,000 more to his children and grandchildren compared to if he had invested the money at 4% gross. When you take into consideration inheritance, federal and state on option 1, option 2 would have been even more of a gain.  

Note:  Any balance left in the qualified account at the parent’s death, could also be used by the beneficiaries (children or grandchildren) to buy life insurance on their parents, much like their parents/grandparents bought life insurance via the trust.  

Considering the new rules on inherited IRA’S, using the life insurance as leverage can make a lot sense. As mentioned, this strategy is highly effective for families in the situation where the RMD is not needed to fund their current lifestyle.  

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