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(rather than as an important asset) because the accounts are subject to income tax during the owner’s lifetime (when withdrawn) or income tax and estate tax at the owner’s death (i.e. when inherited by and distributed to heirs).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).

? 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.

Financing a Roth conversion

Under current tax law, a person who has an adjusted gross income (AGI) of less than $100,000 may convert a traditional IRA to a Roth at any age and without tax penalty. In the year of the conversion, income tax must be paid on the amount converted. On a $1 million Roth conversion, over $400,000 of federal and state income tax might be due. Why would anyone voluntarily pay these taxes?

The reason is that the benefits of converting to a Roth IRA are substantial. Roth IRAs can grow without tax and qualified distributions are generally income tax-free. Also, no required minimum distributions are imposed during the owner’s life. At death, assuming estate taxes are paid, the beneficiary of the Roth need only take RMDs, and those distributions would be income tax-free.

The good news is that starting in 2010, the $100,000 AGI limitation is removed and any person of any income level may convert a traditional IRA to a Roth.Still, the income tax problem remains. But what if someone else paid the income tax?

At the death of the IRA owner, what if the surviving spouse who inherited the IRA also purchased life insurance to pay the income tax due on the Roth conversion? The insurance wouldn’t have to be held in an ILIT, because the death proceeds would be paid to the IRS anyway (as income tax) and should not be included in the spouse’s estate.

Also, premiums wouldn’t have to be gifted out of the estate, since the spouse would own and pay for the insurance personally. And the funds needed to pay premiums could be obtained from annual IRA distributions. If death occurs prior to 2010 and the surviving spouse’s AGI exceeds $100,000, the spouse must hold the death proceeds and wait until 2010 to implement the Roth conversion.

To implement this planning, clients need only do 2 things:

(1) Make sure their spouses are the named beneficiaries of their IRAs and qualified plans.

(2) Make sure their spouses own the correct amount of life insurance on their lives to implement the Roth conversion.

Providing your client with options

As a trusted advisor, your primary objective is to not only help clients keep their financial and estate house in order, but also to understand and offer solutions that can keep that strong financial base stable for the long-term. For many affluent clients, Traditional IRA distributions can be used for a variety of purposes other than to fund a retirement income. The arrangements described above illustrate the versatility of using IRA distributions to achieve diverse financial and estate planning objectives.

Barry Rabinovich, MBA, JD, AEP, is the director of Advanced Markets, MetLife, and can be reached at brabinovich@metlife.com. Lillie Nkenchor is an associate advanced markets advisor in the MetLife Advanced Markets group, and can be reached at lnkenchor@metlife.com