In the insurance and financial planning industry, we understand the power afforded a retirement account by the tax-deferred growth of its values.
Of course, once withdrawals are made from this type of plan, the owner must pay income tax. In addition, at the death of the owner, depending upon the individual situation, the plan can lose more than half of its value to income and estate taxes.
This article will look at the amount of wealth that can be built for multiple generations through Individual Retirement Account stretch-out planning. It will also explore the crucial role life insurance plays in making sure the tenets of this planning are fulfilled. We will focus on IRA stretch-out planning since many clients, after consultation with their tax and/or legal advisors, will roll their qualified plan assets over to an IRA upon separation from service with their employer, if given the opportunity.
To illustrate this, lets look at an example of a client who rolled over a qualified plan distribution into his IRA. This individual, “Mr. Scott Successful,” has an IRA currently worth $1 million. His total estate is worth $4 million and the non-IRA assets are growing at 4% annually. He and his wife, Susan, are both 62-years-old and have two children, Sidney, who is 40, and Sally, who is 38.
From the chart we can see that assuming Scott’s IRA grows at 8% annually until he reaches age 75 and then at 6% annually thereafter, the amount of wealth that can be passed to Scotts heirs is astounding.
Like many married couples, Scott will name Susan as his primary IRA beneficiary and his children as contingent beneficiaries. At her husbands death, Susan can roll over the IRA to her name without any income or estate taxes and may split it into two accounts, one for each child. This split does not have to be equal and can take into account each childs situation.
This is not an irrevocable election, as Susan will continue to control the IRA and has the ability to change either beneficiary at any time. If she is over age 70, as in our example, she will continue to at least take the required minimum distribution amount annually, but based on her life expectancy.
Assuming the children are still the beneficiaries at Susans death, each child would take annual required minimum distributions based on their individual life expectancies. By utilizing separate IRAs, each child can use his or her own life expectancy rather than that of the oldest.
At our estimated growth rates, we can see that this $1 million IRA generated over $6 million of income to Scott, his wife, and their two children. Of course, in order for this plan to work, the IRA must be left undisturbed upon Scott and Susans death.
Under current tax law, estate taxes would apply to Scotts IRA after his and Susans death if they died after 2010. In addition, any money needed to pay these taxes that is drawn from the IRA would result in income tax for the IRA beneficiary.
As our chart shows, approximately $1.1 million of liquidity is needed at Susans death to assure the children the ability to stretch out the inherited IRA.
In order to facilitate the plan, Scott and Susan could create an irrevocable life insurance trust to own a survivorship life insurance policy on their life. They could gift an amount annually to pay the premium and draw the money for the premium from the IRA, paying income tax on the withdrawal. Since Scott is over age 59, there would be no federal 10% penalty on this money.
However, it might be better to draw the funds elsewhere in order to let the IRA continue its tax-deferred growth. There could be gift tax consequences associated with transfers of cash to the trust.
Some clients might question why permanent life insurance inside a trust is needed if there is a possibility that the federal estate tax could be eliminated. First of all, its impossible to know if it will be eliminated. Its also impossible to know exactly how much the IRA will grow and benefit the children in 20 or 30 years. Recent volatility in the markets has clearly shown clients that an 8% or even 6% annual growth assumption is not assured.
The irrevocable trust can act as a back-up plan for the IRA stretch-out plan. If estate taxes are eliminated or the IRA and the rest of the estate drop in value, the life insurance can be held by the trustee and paid to each child on an annual basis similar to how the IRA would have operated. The life insurance proceeds would be received income tax-free by the trust, protected from the childrens creditors and could be invested in a tax efficient manner to achieve the best return possible consistent with the trustees chosen level of risk and trust liquidity requirements.
On the other hand, if the IRA performs well and there are no estate taxes, the trust principal could be held by the trustee for the benefit of the grandchildren or as additional distributions to the children, depending upon their level of need. By providing added protection, the life insurance serves as a sort of air bag for the IRA to make sure that–in almost any situation–the children will fully benefit from the IRA stretch-out plan.
John A. Oliver, CLU, ChFC is vice president, strategic marketing services Transamerica Occidental Life Insurance Company, Los Angeles, Calif. He can be reached via e-mail at John.Oliver
Reproduced from National Underwriter Life & Health/Financial Services Edition, May 6, 2002. Copyright 2002 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.