For most Americans, funding an individual retirement account is a good way to save for retirement. Affluent individuals with large rollover IRAs, however, may already have sufficient non-qualified assets to fund their retirement. Those who do often view traditional IRAs as a “tax liability” (rather than as an important asset) because the accounts are subject to income tax during the owner’s lifetime (when withdrawn) or income tax and estate tax at the owner’s death (i.e. when inherited by and distributed to heirs).
Individuals with sufficient non-qualified retirement savings may be candidates for creative ways to use their IRA assets more productively during their life, such as: (1) financing a new business venture through a bank loan; (2) financing life insurance programs to preserve the estate; and (3) using life insurance to convert a spousal IRA Rollover to a Roth at the owner’s death, thus gaining significant income tax advantages.
Funding a new business venture
Taxable distributions from an IRA can help the IRA owner to fund a new business venture by paying loan interest on a business loan. For example, an IRA owner could take annual distributions from the IRA and use them to capitalize a limited liability company (LLC).
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? If the IRA owner is over age 59 1/2 , these distributions will be penalty-free but income taxable.
? If the IRA owner is under the age of 59 1/2 , then the IRC Section 72(t)(2)(A)(iv) exception could be used to avoid the 10% penalty tax on premature distributions.
This option might be a more attractive alternative for the affluent client than taking a traditional stretch IRA–a vehicle by which to pass IRA assets to children or grandchildren–especially if children or other family members stand to inherit the new business venture, with a full step-up in basis.
In either case, the LLC would still have to borrow money from a bank to fund the new business venture and the IRA owner would have to co-sign the loan. The loan might be arranged as a short-term balloon note so that only interest would be due for the first few years. Each year, the LLC would pay loan interest to the bank from funds contributed to the LLC by the IRA owner.
The LLC would file a form K-1 at the end of the year, the form including deductible business loan interest. By “materially participating” in the business venture, the IRA owner could take an income tax deduction for the loan interest paid to the bank. The deduction could offset income tax due on taxable distributions taken from the IRA, thus creating a “tax offset.” Net result: The IRA helps to finance the deductible carrying costs associated with the business loan until such time as the LLC generates income to pay these costs.
Planning for the next generation
When a person dies, his or her estate may be subject to an estate tax that is paid within 9 months of death. Affluent clients can use life insurance to provide cash to the estate at death, so that the estate taxes due can be paid without selling assets. IRA distributions can be used to help finance this insurance.
An affluent individual can take taxable distributions from his or her IRA and use the after-tax amounts to pay for life insurance premiums by making gifts. The owner and beneficiary of the insurance may be an irrevocable life insurance trust (ILIT), which generally allows the death proceeds to be paid estate and income tax-free. Generally, upon the death of the insured, the estate sells estate assets to the trust to raise the cash needed to pay the estate taxes. This allows the IRA owner’s assets to be preserved for family, friends and future generations.