Make Clients Happy With Qualified Plan Insurance Partnerships
When an individuals estate is faced with using a qualified retirement plan or IRA withdrawal to pay estate taxes, 70% or more of those otherwise tax-deferred funds can be lost almost immediately to taxation.
Similarly, when an individual desires to leave a retirement account to one beneficiary and the nonretirement account assets to another beneficiary, the question often arises of how to pay estate taxes attributable to the retirement account without: (1) making a withdrawal from the account, or (2) burdening the beneficiaries of the nonretirement account assets with the tax liability attributable to the retirement account.
Life insurance can be a perfect solution to these dilemmas. The following “success stories” demonstrate the use of an estate planning strategy known as a “Qualified Plan Insurance Partnership(R)”? (QPIP?), which can allow retirement accounts (including IRAs) to contribute to life insurance premiums without triggering a current income tax, thereby providing a source of tax-free dollars for the payment of estate taxes or any other purpose for which the retirement account participant desires such liquidity.
Case Study #1: Bill and Monica, aged 70 and 69, respectively, are married. The intended beneficiaries of their estates are their children and grandchildren. While Bill and Monica have a significant combined taxable estate, approximately $18 million, their wealth is comprised largely of their retirement accounts: $6 million IRA for Bill and $1.2 million IRA for Monica; and their remaining interest in the family business, a large portion of which they have transferred to their children as part of a lifetime gift program.
Bill and Monicas accountant recommended their grandchildren be designated as the beneficiaries of their IRAs in order to “stretch out” the tax deferral of those accounts for as long as possible after their deaths. A $13 million second-to-die life insurance policy was also recommended to assist in the payment of estate taxes and to replace, for the children, amounts passing to the grandchildren.
Facing an annual premium outlay of $275,000, Bill and Monica needed to identify a source of funds that could be used to cover this expense. Given their limited liquidity, they were uncertain how the premiums would be funded. Bill and Monica were not interested in taking taxable withdrawals from their IRAs beyond the Required Minimum Distributions, which are used for their living expenses. Their insurance advisor suggested the use of the QPIP strategy as the solution, and after careful consideration of the strategy, Bill and Monica decided to use the QPIP (see sidebar for an overview).
Upon establishment of the LLC, Bills IRA contributed $2.7 million in exchange for an 81.82% ownership interest, while an irrevocable trust established by Bill and Monica received a gift of $550,000 from them and then contributed those funds to the LLC in exchange for a 16.67% ownership interest. Finally, Bill and Monica contributed $50,000 in exchange for a 1.51% interest (which they contemplate transferring to the irrevocable trust in the future). Thus, the LLC was capitalized with $3.3 million.
The LLC is expected to generate an annual return of 8%. Based upon this level of capitalization, the LLC should generate sufficient earnings annually to fund the life insurance premiums. Under these assumptions, if the survivor of Bill and Monica dies in year 18 (their life expectancy, based upon IRS tables), then Bills IRA would receive $7,706,716 in return for its $2.7 million investment, while the irrevocable trust would receive $8,578,769. This represents a rate of return of 15.9% for the irrevocable trust and a 6% rate of return for the retirement account.
Moreover, the return to the irrevocable trust would be even greater if the survivor of Bill and Monica dies prior to their actuarial life expectancy.
For example, if the survivor dies in year 6, then the rate of return to the trust would be 65.7%–free of both estate and income taxes.
Case Study #2: Consider the case of Jane, a retired executive of age 60. Janes estate consists of $5 million in her IRA, cash and investments totaling $250,000, and her residence currently valued at $450,000. Jane is also receiving payments pursuant to a deferred compensation plan from her former company for the next 10 years–adequate to cover her living expenses.
Jane would like to leave a net after-tax amount of $1 million to each of her three children, but also is committed to providing significant amounts to a charity upon her death. Janes estate planning attorney explains that this may not be possible in light of the estate and income taxes that could be imposed upon the IRA at the time of her death.
Janes life insurance advisor recommended a $3 million life insurance policy to be owned outside of Janes taxable estate. This policy would allow Jane to provide for her children as stated above, and also permit her to leave her IRA to charitable organizations and thus avoid both income and estate taxes on the IRA.
The scheduled annual premium for the recommended policy is $76,411 for a 10-year period. One of Janes options for funding the premiums was to make taxable withdrawals from her IRA, followed by an after-tax annual contribution to an irrevocable life insurance trust that would own the policy.
This approach would have required, assuming a combined federal and state income tax of 45%, total withdrawals from the IRA of $1.4 million over 10 years. Jane was concerned that such withdrawals could significantly diminish the IRA and thus frustrate her charitable intentions.