Life insurance truly is a multipurpose solution. Savvy financial professionals are leveraging the power of innovative life insurance strategies to counteract some key tax planning and estate transfer needs for affluent and super-affluent consumers alike. Definitions of wealth categories vary, but for the purposes of this article, affluent consumers are defined as having $1 million to $5 million in investible assets (excluding their home) and super-affluent clients as having $5+ million.

First, let’s explore a particular wealth transfer issue that, in my experience, tends to impact affluent as well as super-affluent consumers. Then, we’ll review some other challenges that may impact clients in the two wealth categories.

1. Explore the IRA wealth transfer issue

Many people who have been successful in saving for retirement have established a sufficient nest egg to be able to create a legacy for their children, grandchildren and favorite charities, leaving them to wonder how best to leverage their qualified or tax advantaged retirement plans. A common question is whether individual retirement account (IRA) owners should take larger withdrawals and pay income taxes now, or take out as little as possible during their lifetime, leaving a likely income tax burden for their heirs and beneficiaries.

If an IRA owner seeks to protect loved ones and maximize wealth transfer, he or she can utilize life insurance to minimize the tax burden that inheriting an IRA may impose on a beneficiary. Two solutions described here — a “tax offset” strategy and a “tax elimination” strategy — can help the client maximize the after-tax value of the IRA or eliminate taxes paid on the IRA inheritance.

Keep in mind, however, that this article does not intend to give tax, accounting or legal advice. Any tax statements herein are not intended to suggest the avoidance of U.S. federal, state or local tax penalties. Ultimately though, the strategies described herein are designed to provide significant tax savings, maximize the amount of money beneficiaries receive from IRAs, and offer greater flexibility in how the assets eventually are put to use.  

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2. Consider IRA required minimum distributions

It’s important to give proper consideration to IRA distributions and the resulting tax implications, as these can affect the amount a beneficiary may inherit upon an IRA owner’s death. As you know, beginning at age 70½, the IRA owner must take required minimum distributions (RMDs). Eventually, the RMDs will be larger than the expected annual interest growth.

When that happens, the IRA may well be at its peak value, typically when the account owner is 85-90 years old. (Whether the account is at peak value depends on life expectancy factors, the assumed annual rate of return, and additional deposits or withdrawals made.)  

When an IRA owner dies, the beneficiary must include, in his or her gross income, taxable amounts received. As IRAs frequently are transferred at or near peak value and are fully taxable to the beneficiaries as ordinary income, IRA inheritances are often taxed at very high rates.

3. Think about the current scenario

Before reviewing solutions to help minimize taxes imposed on an IRA beneficiary and maximize the value of the inheritance, consider the current scenario. It’s not uncommon for an IRA owner to reinvest RMDs while using other portfolio assets for retirement and living expenses. This leaves the majority of the IRA balance intact and transferred, along with the tax liability, to the beneficiary at the owner’s death.

Additional deferral may be extended based upon titling and certain beneficiary elections; however, income tax liability will vest upon ultimate distribution as ordinary income. Also, a surviving spouse beneficiary may transfer the IRA into his or her own name and delay distribution until age 70½, but the taxation portion of the IRA at the date of death will ultimately be subject to federal income tax.

If a beneficiary is in the 50s or 60s age bracket (often the case) at the IRA owner’s death and is earning his or her highest career income, he or she will pay taxes at a high income tax rate. The addition of the IRA inheritance to the beneficiary’s existing taxable income could push the recipient into a higher tax bracket. The constraints of maintaining the asset’s tax deferred status may not meet the beneficiary’s existing financial and retirement planning needs.

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Solution No. 1: Offset IRA beneficiary income taxes

In this scenario, the client uses IRA RMDs to help pay for a life insurance policy equal to income tax due on the IRA from the beneficiary at the time of inheritance. Life insurance death benefits are generally income tax-free under Internal Revenue Code 101(a) — although they may be taxable in part or whole under certain situations — so the beneficiary can use the funds to pay the taxes due on the IRA inheritance. The beneficiary then owns the IRA funds and, having paid the income tax on them, may invest/use the full amount of them without penalty taxes or required distributions.

To execute solution No. 1:

  • First – Determine the hypothetical value of the IRA when it would be transferred to the beneficiary.

  • Then – Estimate the income tax the beneficiary would owe if he or she inherited the IRA as a lump sum upon the death of the IRA owner at age 80.

  • Finally – Have the client use a portion of the RMDs to purchase life insurance equal to the beneficiary’s estimated taxes at time of inheritance.

Solution No. 2: Eliminate IRA beneficiary income taxes

By creatively incorporating a charity and the IRA’s RMDs to fund a life insurance policy for beneficiaries in a similar, but slightly different manner as solution No. 1, the federal taxes on the distribution of an IRA can be eliminated.

  • Part 1: Charitable bequest – Determine the hypothetical value of the IRA when it would be transferred to the beneficiary. Then, have the client name a tax-exempt charity as the IRA beneficiary. With the charity’s tax-exempt status, no taxes will be due on the inherited IRA funds.

  • Part 2: Combined legacy – After determining the hypothetical value of the IRA when it would be transferred to the beneficiary and having the client name a tax-exempt charity as the IRA beneficiary, have the client use IRA RMDs to help pay for a life insurance policy equal to the estimated peak value of the IRA. Loved ones can be named as beneficiaries of the policy and as explained, based on current tax law, typically would receive the death benefits income tax-free.

As result of utilizing the combined legacy approach, the total wealth transferred may exceed three times the amount of net after-tax IRA inheritance in the “current scenario” described earlier and the income taxes will have been eliminated. The life insurance policy beneficiary would receive the full death benefit (equal to the estimated IRA value), income tax-free. The charitable IRA beneficiary would receive the full value of the IRA income tax-free at the IRA owner’s death. Zero taxes would be paid on either the IRA or the life insurance policy.

Fees and charges, if applicable, are not reflected in the descriptions of solutions No. 1 and No. 2 and would reduce the amounts described. As stated, income taxes on tax-deferred accounts are payable upon withdrawal. Also, federal restrictions and a 10 percent federal early withdrawal penalty may apply to withdrawals before age 59½. This information is hypothetical and only an example; it does not reflect the return of any investment and is not a guarantee of future income.

It’s just good to know details that may factor into potential solutions, whether for affluent clients or wealthier ones.

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4. Help the super affluent plan for estate taxes

Having covered some strategies designed for affluent and super-affluent clients alike, let’s hone in on another potential role of life insurance for the latter group. In my experience, consumers with $5 million or more in investible assets tend to view life insurance as especially useful in estate tax planning strategies.

With reasonable estate planning, estate taxes typically are paid on the death of the second spouse. If the client’s children were to face a $1 million federal estate tax bill and $1 million were available in an investment account, they could simply write a check to pay the bill. Alternatively, if the client has funded a $1 million second-to-die insurance policy at pennies on the dollar over the years, using the policy’s proceeds may be a more cost-efficient way to pay the estate taxes than writing a check on the investment account.

I’ve observed, however, that many consumers are disinclined to purchase life insurance to leverage in estate tax planning strategies if the product lacks guarantees. Not every second-to-die policy offers lifetime guarantees, even though sales of UL products with lifetime guarantees rose from January to March of this year. Such products are available “because people like guarantees,” as LL Global, Inc. (parent organization of LIMRA and LOMA) shared in its U.S. Retail Individual Life Insurance Sales, First Quarter 2015 report. 

5. Look for guarantees and optionality

The guarantees and optionality of some second-to-die policies are designed to help provide more control and peace of mind during uncertain economic times. Among the features to seek are guaranteed death benefit protection; a flexible continuation guarantee that allows policy owners to select their guarantee period and premium-funding period; guaranteed cash value accumulation that provides flexibility if needed in the future (although accessing cash values may affect the continuation guarantee); and pro-rata adjustments on partial withdrawals that allow the policy to remain in force with a proportionally reduced death benefit, cash values and guaranteed premium.

Be sure to share with the client that the guarantees of survivorship life products are backed by the claims-paying ability of the issuing insurance company, and are subject to the policy’s terms and conditions. Partial withdrawals or loans typically will reduce the death benefit and cash value, and could reduce the duration of coverage. Partial withdrawals may be taxed as regular earnings and therefore, as explained, clients should consult a tax advisor when considering their own situations. It’s important for the tax expert to determine whether a transaction is a taxable event.

Ultimately, however, when planning with clients for estate tax obligations, I believe you’ll find a survivorship life policy featuring guarantees and optionality to be a sound financial decision for clients who can purchase such a policy. 

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6. Share other solutions with the affluent

Federal estate taxation is not customarily an issue for clients with less than $5 million in investible assets, but they may face other challenges for which strategically leveraged life insurance might be an appropriate solution. For example, a small business owner might purchase a universal life insurance policy with a goal to help equalize the transfer of his or her estate among various family members helping to run the company and beneficiaries who are not involved with it.

Similarly, for today’s modern, blended families, a UL product might be used to equalize an estate between a client’s natural children, kids who have come into the family through remarriage, a special needs grandchild, etc. Also, a permanent life insurance contract, when suitably funded and structured with a package of living benefit riders, may help counter financial risks of longevity and chronic illness (for policy holders who meet the rider eligibility criteria).   

Whether working with affluent or super-affluent consumers, seize the opportunity to enhance their understanding of the powerful potential for life insurance strategies to help mitigate income or estate taxation, facilitate efficient wealth transfer, and impart a larger legacy to loved ones or a beloved charity. Innovative solutions are at the ready.

See also:

The case for skipping the 401(k)-to-IRA rollover

Total retirement assets near $25 trillion mark

Why IRAs need designated beneficiaries