Life insurance and Roth IRAs have a basic structure in common. They are both wealth transfer tools that help facilitate an efficient transfer of assets from one generation to the next; and they both can provide a tax-free legacy.
Despite their many similarities, Roth IRAs and life insurance are very different, and the rules that apply to one don’t always apply to the other. In fact, more often than not, that’s the case. Below, we discuss 3 of the biggest differences between the two vehicles.
#1: Roth IRAs are always included in your estate
Thanks to the 2015 $5.43 million federal exemption amount — the amount that can pass estate tax free to beneficiaries — estate tax concerns are nowhere near what they used to be. The overwhelming majority of clients will not owe federal estate tax when they die.
Yet, a small segment of the population has to contend with such concerns. Plus a number of states still impose state estate taxes; and many of those states have set their exemption amounts much lower than the one available at the federal level. In such cases, life insurance may offer an advantage over Roth IRAs.
Here’s the deal in a nutshell: The “I” in IRA stands for individual, meaning it’s always your clients’ asset; and, therefore, the value of the Roth IRA is always included in their estate. If your clients are above the federal estate tax exemption amount or their applicable state estate tax exemption amount, their beneficiaries could end up owing estate tax — at the federal level, state level, or both — on what they thought were “tax-free” Roth IRA assets.
Life insurance, in contrast, can be structured so that it’s outside of clients’ estates, producing not only an income tax-free benefit to their heirs, but also one that is not subject to estate tax, regardless of the value of their estate when they die. In other words, it is a truly tax-free benefit.
There are a variety of ways to accomplish this, including having an irrevocable trust (or, alternatively, clients’ children or other interested parties) purchase the life insurance policy. To figure out which option is best, consider bringing an estate planning attorney into the mix.
One final note about the $5.43 million estate tax exemption: it’s a “permanent” exemption that’s indexed for inflation. “Permanent” though, in Washington speak, doesn’t actually mean permanent. It just means “until we change our mind and pass a new law that supersedes this one.” So though the estate tax exemption is high enough today that most clients don’t have to worry about it, there’s no guarantee that will be the case when you client dies.
#2 – There’s a limit to the amount you can contribute to a Roth IRA
When it comes to the tax code, there is a giant, gaping, Grand Canyon-esqe hole for life insurance. Sure, insurance carriers may limit the amount of insurance they’ll offer based on various factors, including your client’s health, annual income and net worth, but that has nothing to do with the tax code.
As far as Uncle Sam is concerned, they can have as much insurance as they want, or perhaps, more accurately, as much as they want and they can get. In contrast, if they want to make annual Roth IRA contributions, they’re fairly restricted.
For 2015, they can contribute no more than $5,500 ($6,500 if age 50 or older by the end of the year) to a Roth IRA. They can also convert an existing IRA or eligible retirement plan funds to a Roth IRA.
There is also no rule about what type or how much income clients must have to purchase life insurance. Roth IRA contributions, however, do have such restrictions.
Roth IRA contributions, for instance, can only be made with income that qualifies as “compensation,” which is typically earned income. In contrast, life insurance premiums can be paid with any type of income, including interest, dividends and Social Security, all of which are not considered compensation.
For that matter, if your client had no income, they could simply pay for life insurance premiums from existing assets (although in reality if they have assets, they’re almost certainly going to have some income, even if it’s just interest).
When many clients really begin to focus on legacy planning, they’re already retired, or close to it. Therefore, their ability to make Roth IRA contributions is usually limited. There are no similar issues with life insurance.
There are issues on the other side of the income spectrum. too. If you have too much income, from whatever sources, you are prohibited from making Roth IRA contributions. (To see those limits, click here.) With life insurance, there’s no limit to the amount of income a client can have. All things being equal, they can generally qualify for more life insurance with a higher income.
#3 – There are no RMDs for life insurance
When clients leave a Roth IRA to non-spouse beneficiaries, such as children, the beneficiaries must generally begin taking RMDs (required minimum distributions) from the inherited Roth IRA no later than the year after they inherit. These distributions are usually tax-free, but they must be taken nonetheless.
When beneficiaries inherit life insurance, there are no RMDs to worry about. Here’s something to consider, however. While not having to deal with RMDs is nice, that fact doesn’t necessarily make life insurance a better — or more tax-efficient — option for legacy planning than a Roth IRA.
Consider the following: When a beneficiary inherits life insurance, the only amount they’ll receive tax-free is the actual life insurance proceeds. If they don’t need the money right away, they might invest the proceeds, but whatever interest, dividends, capital gains or other income those investments generate will be taxable (unless they are invested in assets that don’t produce taxable income, such as municipal bonds).
In contrast, while the inherited Roth IRA will have RMDs to deal with, those amounts may be relatively minimal and the future growth in the Roth IRA remains income tax-free.
Take someone who inherits a Roth IRA at age 50, for example. In this case, RMDs would start out at roughly 3 percent of the account value. The rest of the Roth IRA, however, can be left alone to grow, and that growth can later be distributed tax-free as well.
So, whereas a beneficiary of a $500,000 life insurance policy will “only” receive $500,000 income tax-free, a beneficiary inheriting a $500,000 Roth IRA may receive many times that amount in tax-free distributions over the course of their lifetime, particularly if they stick to taking only the RMD each year and no more.
A final thought
If your clients are looking to leave a legacy to their heirs when they die, there are many tools to consider. Life insurance and Roth IRAs are but two of the many options.
In some cases, life insurance may not be available due to poor health. In other cases, such as when your client’s beneficiaries will be in a lower bracket than they are now, there may be a greater net benefit by leaving them larger amounts of tax-deferred accounts, like IRAs instead of a smaller amount of Roth IRAs.
The bottom line: Every situation is different and there’s no one-size-fits-all solution. Surely though, Roth IRAs and life insurance offer two potentially very efficient options.
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