Think about affluent clients with estates subject to estate taxes. Do they hold significant assets in individual retirement accounts or qualified retirement plan accounts? Do they intend to transfer these accounts to children and grandchildren? Do they recognize the erosion attributed to estate and income taxes?
For this discussion, the affluent refers to people whose estate size would subject their estate to federal estate taxes upon death. They are business owners and highly compensated executives and consultants who have found qualified retirement plans to be an effective means for accumulating assets in the working years. As a practical matter, many have no need or intention to tap into those assets in retirement. Instead, frequently, they intend to pass these assets on to their children and grandchildren.
When IRA and other qualified plan assets are incorporated into the family estate plan, a so-called “stretch IRA” strategy is typically explored. The goal: to keep the qualified assets income tax deferred as long as possible.
However, this must be done with care, so that the plan accomplishes its purpose.
In the traditional stretch IRA:
o The account owner only takes withdrawals when forced to by tax law–as “required minimum distributions” (RMDs)
o At the death of the account owner, her spouse takes the IRA as his own and re-establishes the RMD amounts and timetable.
o Upon death of the surviving spouse, the IRA is passed onto the children as an “inherited IRA” and the RMDs are reset based on age of the oldest beneficiary.
o At the death of a child, their children (the grandchildren of the original account holder) take the remainder based on the RMD timetable established for their parents.
That sounds simple enough. But, there is more to it.
Although typical stretch arrangements do provide withdrawal flexibility for future generations and provide potential tax deferral, they generally fail to address the erosion of values due to taxes and the timing of distributions. Therefore, it’s important to recognize that stretch IRAs have built-in disadvantages.
Some examples include:
–All withdrawals are subject to income tax to the recipient (2008 federal maximum 35%).
–Account values are included in the estate of each succeeding generation and may be taxed in more than one generation (2008 federal maximum 45%).
–RMDs will reduce account values and trigger income tax as received.
–Each succeeding account beneficiary only gets what is left by the prior beneficiary, which could be nothing.
–The grandchildren may have to wait an inordinate amount of time to benefit from their grandparent’s IRA account
Review the example of tax erosion on a $1 million stretch IRA in Table 1. Then consider this: For all IRA and qualified plan account holders, income taxes will diminish what is left for retirement and heirs. However, for the affluent, tax erosion poses a more significant threat especially to values left to heirs.
For instance, when assets are transferred to the next generation, the erosion could be as high as 35% from income taxes, 64% from a combination of income and estate taxes, and 80% from a combination of income, estate and generation skipping taxes. So, $1 million left in an IRA could shrivel to only $196,375.
In addition, successive transfers to future generations may trigger additional future estate taxes.
As noted above, if an IRA is stretched out to its fullest, the children and grandchildren may have to wait an inordinate amount of time to receive their interest. When they’re finally eligible, the account value may have been decimated by investment results, RMDs or other lifetime withdrawals.
Example: Assume the client is an account holder, age 65, with a spouse age 65, a daughter age 45 and a grandchild age 25. Based on life expectancies, the daughter may have to wait 28 years (age 73) before receiving her inheritance. The granddaughter may have to wait 43 years (age 68) before gaining access to the account.
But there is a strategy that can help. This entails using life insurance to arrange for the latter generation to be better positioned without using anything but the IRA assets themselves–like getting a bump-up from coach to first class in an airline. Here’s how it works:
1) The account holder (grandparent) creates an irrevocable trust as an independent funding source to benefit their children. The trust would be funded with a survivorship life insurance policy. This would make the benefit available at the same time as the IRA benefit would have been, after both parents’ death.
2) At the same time, arrangements are made to have the grandchildren step up as the designated beneficiaries of the IRA account instead of their children.
Consider this case study: Dad and Mom are age 70 and 65 respectively. Dad has $1 million in an IRA account which is set up to pass to their daughter (age 45) after their deaths. Based on the account value, a projected growth rate (5%) and an assumed date of death (10 years for the account owner and 20 years for the spouse), the value of the account available to their daughter is projected to be $1,174,615.
The strategy: Dad and Mom purchase a survivorship life policy with a death benefit equal to the $1,174,615 that’s projected to be available to the daughter upon their deaths. The policy is owned by an irrevocable life insurance trust (ILIT) for the benefit of the daughter.
Having reached age 70 1/2 , Dad will be forced to take required minimum distributions from the IRA. In the first year, the RMD is projected to be $36,496; after taxes, this would leave $23,722. These RMD amounts, or some portion of them, can be used to make gifts to the ILIT and used to pay the policy premium, $19,247.
Properly arranged, the transfer to the trust can qualify for the annual gift tax exclusion as gifts from Dad and Mom to the trust beneficiary. In addition, Dad and Mom will make their grandson the contingent beneficiary of Dad’s IRA and have it documented that, if Dad dies first, Mom will make their grandson the beneficiary of the IRA values she inherits from Dad. (See Table 2.)
What did Dad and Mom accomplish?
o Substantially increased the net amount available for their daughter.
o Made funds available a generation sooner to their grandson.
o Increased the net amount available to their grandson.
o Protected the benefit payable to their daughter from investment risk (as long as the premiums are paid).
o Avoided the risks of loss on the account values.
In effect, they have “bumped up” both generations, from coach to first class.