Dont S – t – r – e – t – c – h That IRA
Do Better Results With Innovative Life Insurance Applications Can Produce Better Results For The High Net Worth Client.

Transfer tax planning for high-net-worth clients often includes designing a distribution plan for the clients significant individual retirement account (IRA). Many planners suggest that the best results flow from deferring or “stretching” the IRA pay-out over the life of the client and one or more of the clients children.

A stretch plan has positive benefits in an estate that will not be subject to transfer taxes (i.e., federal and state estate tax and generation-skipping transfer tax), but for clients who will be subject to a transfer tax, planners should avoid the impulsive knee-jerk “Stretch IRA” suggestion.

Instead, consider using innovative life insurance applications that can produce, under the correct circumstances, a significantly better net result after transfer and income taxes result. This article discusses two insurance- driven IRA planning ideas which produce this better result. Before we get started, though, lets define some terms.

What will Congress do to the Federal estate tax?

Simply put, I dont know and Im not going to guess. Ill just say that for the purposes of this article and the calculations that are summarized, Ive assumed that the federal estate tax system adopted by the 2001 Act remains unchanged for the foreseeable future. Accordingly, effective January Jan. 1, 2011, the tax-reducing provisions of the act will “sunset” and we will be returned to the estate tax law currently in effect.

What is a Stretch IRA?

In a typical Stretch IRA plan, the pay-out of the clients IRA is postponed until after the client reaches age 70 1/2 and the client designates a child as the beneficiary of the IRA. A long pay-out period with reduced payment amounts is produced.

This structure satisfies the wishes of most high-net-worth clients because it allows the client to take minimum distributions over his or her life and leave a larger IRA balance for the child beneficiary. The pay-out to the child is then spread out over the childs remaining lifetime.

The tax consequences of the Stretch IRA are reasonably straight forward. First, the balance of the IRA at the clients death is subject to transfer tax. Additionally, the IRA is considered” income in respect of a decedent”. To avoid double taxation (i.e., both estate and income tax on the same IRA dollar), the child beneficiary receives a federal income tax deduction for the federal estate tax payable on the IRA (known as a “691(c) deduction”).

When is a Stretch IRA a bad idea?

The benefits of the Stretch IRA stem from the prolonged period of income-tax- free accumulation and income deferral. Clearly, money that can be invested in an income-tax- free account will outgrow money that is invested in a taxable account. If, however, the IRA must pay its share of transfer taxes in an taxable estate, then no amount of income tax deferral can make up for the loss of up to 55% of the accounts value. This is the central problem with the stretch plan. Accordingly, it is safe to say that whenever an IRA will be subject to transfer tax at the clients death, use of a Stretch IRA may be a bad idea. What alternatives exist?

10- Year Take Down

For “younger” clients (typically between ages 60 and 75), a “10- Year Take-Down Plan” can produce better results. As the name implies, the client completely withdraws the IRA over a 10- year period. Because Since the client does not need the IRA for his or her support, the entire net after income tax payment is gifted to an irrevocable life insurance trust (an “ILIT”) that contains annual withdrawal rights (i.e., Crummey rights).

Ideally, the annual gifts to the ILIT are gift tax- free. The trustee of the ILIT purchases a life insurance policy on the client. Obviously, policy design is important.

At the clients death, no estate tax is due on the IRA (its gone) and the insurance proceeds pass to the family estate- and income tax- free.

That sounds good, but lets look at the numbers to make sure. I Let’s compared the net after tax (income and transfer) effects of a Stretch IRA plan to a 10- Year Take-Down plan.

Consider your client, age 65 and in good health, looking to pass assets on to his daughter, age 39. He’s got a net worth of $5.5 million, which consists of $4.5 million of non-income-producing assets and $1 million in an IRA. He doesn’t need the IRA; his income needs are satisfied elsewhere. He’ll always be in the 35% tax bracket, as will his daughter.

I made the assumption the IRA would grow at 10% annually, and I also assumed a 10% present value discount rate.

For the Stretch IRA comparison, our client will start taking payments at age 70 1/2. We’ll reinvest those after tax payments into equities producing 9% capital growth with 1% annual dividends, also reinvested. At the time our client dies at age 86, his daughter will inherit the IRA, withdraw the estate tax and receive the balance over the rest of her life.

To compare this with the Ten10- Year Take-Down plan, we will begin taking 10 annual payments from the IRA beginning at age 65. After-tax amounts of $96,000 will be given gift tax-free to an ILIT holding a $1 million life insurance policy. The policy death benefit will grow to $3.1 million in the assumed year of death.

For the sake of our comparison, our client’s daughter will receive the death benefit plus earnings and appreciation over her lifetime using the same method used under the Stretch IRA plan. By recovering the income-tax- free death benefit over her remaining life expectancy, 24 years, she will receive the first $131,666 each year income tax- free.

These results are in Table 1 and 2. The results in Table 2 use a discounted present-value analysis to compare results.

As shown, the 10- Year Take-Down plan can produce significant increases above a Stretch IRA plan for younger clients.

Annuitize/Insure Plan

For clients at age 75 and above, the planner should consider an Annuitize/Insure plan as an additional alternative. In this plan, the IRA custodian purchases a straight life-only commercial annuity on the clients life. The net after income tax annuity payments are gifted to an ILIT.

Within the ILIT, the Trustee purchases a life insurance policy on the client from a company different than the annuity issuer. Policy design is again important. With this plan, at the clients death, the annuity terminates, zeroing out the IRA, and the ILIT collects the insurance proceeds estate- and income tax -free. Lets go back to the calculator to compare the effects of this plan to a Stretch IRA.

We’ll change a few of the assumptions we made in the prior example. The assumptions which differ from those set out above are:

Assume our client is 75 and in good health, his daughter is 49. We are projecting his life expectancy another 14 years.

The annuity we will be using generates a net after tax income of $81,000, all of which will be given gift tax-free to an ILIT to purchase a life insurance policy. The death benefit will be $1 million, but will grow to almost $1.7 million at our client’s death.

Once again, our client’s daughter will receive the death benefit distribution in the same method used under the Stretch IRA plan. The income-tax-free death benefit over her remaining life expectancy, 22 years, results in the first $76,600 each year received income tax- free.

These results are in Table 3 and 4. The results in Table 4 use a discounted present-value analysis to compare results.

A mere 9% increase, you say? Im sure the daughter would prefer the extra. Also, dont forget that the Stretch IRA plan produces an asset that is includable in her estate. In contrast, the ILIT can be designed to avoid transfer taxes at her death and at the deaths of future generations to come.

As demonstrated, the Stretch IRA plan should be avoided in planning taxable estates. Instead, a better result can be achieved by using innovative insurance planning ideas to answer one of our clients most important planning questions.

Douglas A. Walker, JD, a partner at Holland and Knight, LLP, in Ft. Lauderdale, Fla., practices in the areas of trusts and estates, federal taxation, deferred compensation, corporate mergers and acquisitions and general corporate representation. He can be reached via e-maill him at dwalker@hklaw.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, August 13, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.


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