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How to create a tax-advantaged legacy using life insurance

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As clients get older, they often express two recurring themes about their children: (1) “I don’t want to be a burden to them;” and (2) “I don’t want them to have any additional expenses or taxes after I die.” While there may not be a lot that an independent producer can do about the former, there is something that can be done about the latter.

Tax-advantaged planning

When clients have assets to leave to their children or grandchildren, they want to pass them on as quickly and as efficiently as possible. For the vast majority of clients, estate taxes are no longer an issue, with the estate tax exemption being above $5 million.

However, most clients do not consider income taxes, which can deplete the value of property passing to their beneficiaries. Specifically, for those intending to leave Individual Retirement Accounts to the children or grandchildren, the value of the accounts could be significantly reduced by income taxes.

This effect is amplified as the beneficiaries are more likely to be in high income-tax brackets when they receive the inheritance. Additionally, 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.  

Beneficiaries of retirement accounts have to pay income tax on the distribution in the same way as the account holder. This is something account owners often do not understand.

While beneficiaries can “stretch” IRA distributions or defer for five years, these options are rarely selected; the favored option is to take a lump sum as quickly as possible. The only good news is that the ten percent penalty is not applicable regardless of the age of the beneficiary.

So the end result of leaving IRAs to children as a legacy is often that only part of the IRA—often 70% or less at today’s income tax rates—will end up in the hands of the beneficiaries. On the other hand, if Mom or Dad are in a lower income tax bracket had taken distributions from the IRA and transferred the net funds into an asset that does not have the associated income tax liability, the value of the legacy could be increased.

The asset most commonly used is a life insurance policy with a no-lapse guarantee. No-lapse guarantee products provide clients with a guarantee of the amount of the death benefit, as long as the requisite premium has been paid. Single premiums or short-pay scenarios are used to enhance the available death benefit.

The ideal client is retired, 60 or older,  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. Since 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. 

When looking to re-position an IRA, an important step is deciding how to structure the transaction, as withdrawals from the account will be taxable. Clients under age 59 ½ may be subject to the 10% premature distribution penalty, so this technique is generally not economic for them. 

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. Because required minimum distribution (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 such as five to ten years.

If the client dies during the distribution period, the beneficiaries will inherit two assets: the life insurance and the IRA. The important planning consideration is making sure the premium paid is sufficient enough to guarantee the death benefit.

Living benefits

Though clients have adequate assets for day-to-day needs and emergency situations, they may still be hesitant to proceed because of the nagging concern that they might need access to the funds in the future. As a result, they prefer to do nothing rather than create an asset that is not within their reach. To address this concern, several no-lapse guarantee life insurance products also offer additional flexibility through access to cash value in early years, return of premium or accelerated death benefits.

Typical triggers for accelerated death benefits are terminal illness, chronic illness and specified medical conditions. Although definitions vary widely, terminal illness typically 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 or having a permanent cognitive impairment. Specified medical conditions are defined within the policy, and may include such events as a heart attack, stroke, organ transplant or diagnosis of life threatening cancer.

If the client has any of these “triggers,” then some portion of the death benefit is available as an accelerated death benefit. 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.

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 that 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 adviser proposes using distributions from the IRA to purchase life insurance to provide a tax advantaged legacy for her children. 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 using a single premium of $80,000, she could purchase a death benefit of over $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.

The result is a win-win for all parties. Review your existing clients to see who is a fit for this strategy and talk to them about maximizing their legacy.  

The tax information and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Columbus Life does not provide estate planning, legal, or tax advice. Columbus Life cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Columbus Life makes no warranties with regard to such information or results obtained by its use. Columbus Life disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.

Columbus Life is licensed in the District of Columbia and all states except New York.