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Life Health > Life Insurance

Maximizing Modest Legacies

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Leaving a legacy is important for most clients. Even those with moderate estates have assets earmarked in their own mind as “for the children” or “for the grandchildren’s education.” Many of these clients assume the full value of these assets, whether they are savings accounts, CDs, annuities or retirement accounts, will pass to the beneficiaries. For most of these clients, estate taxes haven’t been a real concern in the past, and they are unlikely to be so in the future if the estate exemption stays at anything close to the current $5 million level.

What is much more likely to reduce the value of the legacy to these clients’ beneficiaries is the income tax liability. For those intending to leave IRAs to children or grandchildren, the value of the account will be reduced by income taxes, and this effect may be amplified if the beneficiaries are in high income tax brackets when they receive the inheritance. The typical inheritance is received when the beneficiary is in his or her 50s — a time when earning potential and income is usually at its peak.1

See also: Adding Values to the Boomer Estate Plan

Beneficiaries of retirement accounts have to pay income tax on distributions in the same way as the account holder. Unlike some other assets, the income tax liability does not go away, which is something many account owners do not understand. Beneficiaries also do not have the ability to defer distributions from inherited IRAs or to rollover the balance to their own account. They do have the option to “stretch” IRA distributions over their (or someone else’s) life expectancy, or they may be able to defer for five years, but these options are rarely selected, particularly when the IRA balance is modest. The favored option is to take a lump sum as quickly as possible. The only good news is that the 10% penalty is not applicable to these distributions, regardless of the age of the beneficiary.

So the end result of leaving an IRA as a legacy is that only a part — often 70% or less — will end up in the hands of the beneficiaries. On the other hand, if mom or dad had taken distributions from the IRA at his or her lower tax bracket and transferred the funds into an asset that does not have an associated income tax liability, the value of the legacy could be increased and the tax liability decreased.

Repositioning assets

Capital transfer is the process of repositioning the assets that have adverse income tax consequences for the beneficiaries into an asset that will provide more favorable tax treatment and increase the overall amount left to the beneficiaries. The asset most commonly used is a life insurance policy with a no lapse guarantee. No lapse guarantee products provide clients with a guaranteed death benefit as long as the required premium has been paid. For capital transfer, single premiums or short pay scenarios are used to increase the available death benefit. As discussed later, some products also offer flexibility for clients to take distributions in exchange for a lesser death benefit.

The ideal client for capital transfer is someone who has sufficient assets and income to live on, has a sufficient reserve for emergencies and wants to leave a legacy to children, grandchildren, charity or other friends and relatives. Whether the client has sufficient assets will be determined on a case-by-case basis, dependent on the client’s comfort level with his or her current assets. Because life insurance is involved, the client will have to be healthy enough to get life insurance and be willing to go through the underwriting process.

Structuring the transition

When looking to reposition an IRA, an important step is deciding how to structure the transaction, as withdrawals from the account will be taxable. A single premium will generally offer the maximum death benefit but will often result in the highest tax liability to the client. If the client does not want to pay the income tax liability in a single year, withdrawals and the resulting insurance premium can be spread over a number of years. What’s most important is making sure the premium paid is sufficient to guarantee the death benefit.

For the client who wants to spread the tax liability over more than one year, the producer can set up an arrangement whereby the client liquidates the account over several years. Or producers can set it up so the RMDs are used to fund the life insurance policy. Because RMD amounts are variable and it is important to have sufficient funds to pay the required premium, it is generally better to set up level withdrawals over a period of, say, five to 10 years. The simplest way to do this is to divide the account balance by the number of years for withdrawals. The number could be increased for growth in the account or just leave any balance remaining in the account to pass to the beneficiaries as originally planned. If the client dies during the distribution period, the beneficiaries will inherit two assets, the life insurance and the IRA.

Adding flexibility

Even though capital transfer clients have adequate assets for day-to-day and emergency needs, they cannot be sure they will never need to access the funds. As a result, rather than create an asset that is not within their reach, they may prefer to do nothing. To address this concern, several no lapse guarantee life insurance products also offer living benefits and options to access cash value. Living benefits accelerate the payment of part of the death benefit and are available on the occurrence of terminal illness, chronic illness or a specified medical condition.

Terminal illness means the client has a life expectancy of less than 12 or 24 months, depending on the state and carrier. Chronic illness is usually defined as the inability to perform two to six activities of daily living, although some states and policies require nursing home confinement. “Specified medical condition” is defined in the policy and may include such events as a heart attack, stroke, organ transplant or diagnosis of life-threatening cancer.

See also: Life Insurance Sales: Emphasizing the “What’s In It for Me” Factor

Amounts available depend on the relevant trigger and vary considerably between carriers — some use a simple percentage formula while others may require additional underwriting to determine the amount of the advance. For many clients, the availability of the advance will be sufficient to overcome the reluctance to purchase insurance, as these triggers match the situations in which they might expect to need access to the underlying funds.

For clients who want more security in terms of being able to access cash, some products offer increased cash accumulation during the early years of the policy, including, in some cases, a return of premium feature for a number of years. This may help provide added peace of mind that funds are available in the future if needed. The tradeoff is that the guaranteed death benefit is generally lower. For products offering access to cash value, it is important to know if the client takes a withdrawal from the cash value in the policy, whether the death benefit guarantee will be reduced or whether the death benefit guarantee will disappear completely.

Let’s take a quick look at an example to see how this might work. Mary, age 70, standard non-smoker, has an IRA with a balance of $100,000. Mary has sufficient other assets and income and will not need the required minimum distributions when she has to start taking them next year. Mary understands her children will have to pay income tax on the account when they inherit it. Her children are successful and pay income taxes at a much higher rate than she does. The producer proposes a capital transfer strategy for Mary. Mary will take $10,000 a year from the IRA and, after paying income tax, will use $8,000 to fund a life insurance policy with a guaranteed death benefit.

Since Mary does not expect to need this asset in the future, she wants the maximum death benefit rather than building cash value. Mary can purchase a death benefit of approximately $145,000. As a result, when she dies, her children will receive the death benefit income tax-free and the remaining balance of the IRA. If Mary wants to increase the death benefit by paying a single premium of $80,000, she could purchase a death benefit of more than $180,000. Either way, the children are likely to receive significantly more than if Mary had left the money in the IRA and the children had to pay income tax at their tax rates.

Getting started

With a win-win for all parties, it’s time to get started. Look for clients who have IRAs they do not need for living and emergency expenses and talk to them about a capital transfer solution for the IRA or for part of a bigger IRA. With the potential for higher income tax rates in the next few years, particularly for those at the highest income levels, the time is right to start the transition to minimizing the overall tax rate associated with transferring assets. Review available products and make sure you select one for your client that has the features they want and is able to provide flexibility in the future.

With this planning, you can help your clients as well as provide a greater benefit for the next generation. Maybe the next generation will even thank you for this planning and want you to help them!


  1. BLS (Bureau of Labor Statistics) “Inheritances and the Distribution of Wealth” January 2011

For more on estate planning, see:

The Accumulation SLAT: Tailor-Made for Gen X

Beneficial Estate Planning Climate

Estate Planners: 5 New Taxes to Watch


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