Advanced Sales September 2017 Blog

Creating an Inherited IRA Legacy Plan with Life Insurance Funded by After-Tax Distributions

With the recovery of the equities markets after the economic downturn of 2008-2009, it is common for successful business owners, professionals, and other individuals to have more than $1,000,000 in their IRA account.

Many of these IRA owners have multiple sources of income as they approach their retirement years. These sources could include continued earned income from a profession, Social Security retirement benefits, K-1 pass-through income from ownership of S Corp or LLC entities, rental income from real estate, and other interest, dividends, or capital gains from non-qualified financial assets.

These IRA owners understand that Required Minimum Distributions (RMDs) must be taken from their IRA starting when they turn 70 ½. The question that typically arises in their financial planning is what to do with the after-tax amounts from their RMDs? For IRA owners with multiple sources of income, these after-tax RMDs are usually allocated as some form of inheritance to their heirs. Should these after-tax amounts simply be re-invested in their non-guaranteed financial asset portfolio or is there a more tax efficient way to re-allocate these funds that could provide a larger inheritance to their family?

The concept that can provide a larger after-tax inheritance is commonly known as the Inherited IRA Legacy Plan where after-tax RMDs are allocated to an annual premium for a no-lapse UL or no-lapse SUL life insurance product.

The actuarial leveraging and income tax-free life insurance death benefit can provide a larger inheritance by life expectancy and beyond than simply re-investing the after-tax RMDs in an asset portfolio with taxable yields. This is especially true in the continuing low-interest economic environment for fixed financial assets.

A Basic Blueprint for the Inherited IRA Using Life Insurance

Here are the steps of the inherited IRA transaction to provide a leveraged tax-free fund for heirs in the form of life insurance:

First, create an income stream from the IRA by taking distributions from the IRA. An IRA owner doesn’t need to wait until age 70 ½ to take distributions from an IRA. Some IRA owners may wish to wait until 70 ½ while others may find it beneficial to start distributions prior to 70 ½. Starting prior to 70 ½ may work when coupled with a life insurance program because of the usual higher premium cost of waiting. Also, the onset of certain medical conditions as we get older that may result in less favorable underwriting may be a good reason to consider starting IRA distributions prior to 70 ½.

The income stream from the IRA is taxable, but the after-tax dollars can be used for a premium on either personally owned life insurance or insurance owned by an irrevocable life insurance trust (ILIT).

The decision on personal ownership or ILIT ownership will depend on factors such as the size of the IRA gross estate in relation to the $5.49 million (single) and $10.98 million (married) federal estate tax exemption in 2017. Also, the simple size of the death benefit may dictate ownership by an ILIT whether or not the IRA owner has an estate large enough to worry about federal estate taxes. Certainly, many IRA owners may be exposed to state death taxes because of the lower state death tax exemptions of many states that still levy state death taxes.

Who shall be named as the beneficiary of the life insurance? Shall it be the children of the IRA owner outright or an ILIT for their benefit? Or shall it be an ILIT for the benefit of the grandchildren of the IRA owner?

Who shall be named as the beneficiary of the IRA? Shall it be the children of the IRA owner outright or a trust for their benefit so the inherited IRA can be paid over the children’s life expectancy? Or shall it be a trust for the benefit of the grandchildren so the inherited IRA can be paid over the longer life expectancy of the grandchildren?

Case Study of Inherited IRA Using After-Tax IRA Distributions for Life Insurance versus Using After-Tax Distributions for Alternative Fixed Financial Asset

Facts of Case Study:

Client and spouse are 71 and 70 respectively and have a current gross estate of $5,000,000. The client owns an IRA worth $1,000,000 and must start taking RMDs. They have other sources of retirement income including Social Security benefits, income from rental properties, and interest, dividends, and capital gains from their non-qualified asset portfolio. They ask you, their financial professional, to make a study of what to do with the after-tax RMDs that must start to be distributed from the IRA. Their combined federal and state income tax bracket is estimated at 35%. They feel that an after-tax return on their non-qualified asset portfolio is 5% going forward.

SCENARIO #1

Place After-Tax RMDs in an Asset Allocation Portfolio at 5% After-Tax Rate of Return (ROR)

  • The factor from the Uniform Distribution Table for a 71-year-old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
  • This after-tax amount of $24,528 will be re-allocated each year into the non-qualified asset portfolio with an assumed after-tax ROR of 5%.
  • The joint life expectancy of a male 71 / female 70 from the government joint life expectancy table is about 20 years.
  • An annual deposit of $24,528 into a non-guaranteed financial asset for 20 years at 5% after-tax ROR would provide a fund value of $852,000. This is the hypothetical non-guaranteed amount that would be inherited by the heirs of the client and spouse.

SCENARIO #2

Place After-Tax RMDs in a No-Lapse Survivorship Universal Life (SUL) Policy for Male Age 71 (Standard NS) and Female Age 70 (Standard NS)

  • The factor from the Uniform Distribution Table for a 71-year-old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
  • This after-tax amount of $24,528 will be re-allocated each year into a premium for a no-lapse SUL insurance policy issued by a competitive carrier.
  • An annual premium of $24,528 will purchase a guaranteed SUL death benefit of $1,172,000 right from the beginning. This is the tax-free amount the heirs would receive at the death of the survivor of the client and spouse. The IRR at year 20 joint life expectancy is 7.72%. In a 35% tax bracket, the pre-tax equivalent IRR is 11.88%.
  • Instead, if very good health was able to provide a Male 71 Preferred NS and a Female 70 Preferred NS medical underwriting result, the $24,528 annual premium would purchase a guaranteed SUL death benefit of $1,352,000. The IRR at year 20 joint life expectancy is 8.90%. In a 35% tax bracket, the pre-tax equivalent IRR is 13.69%.

Summary of Benefits for Inherited IRA Plan with Life Insurance

The benefits of channeling after-tax IRA distributions into guaranteed no-lapse life insurance are significant. When compared to the taxable yields of alternative fixed financial assets (Money markets, bank CDs, bond funds, U.S. government securities), in the continuing low-interest environment, the net results are truly outstanding.

  1. The net inheritance to the heirs of the IRA- SUL life insurance plan shown above is hypothetically improved by about $320,000 at joint life expectancy (20 years) with standard medical underwriting when compared to alternative financial assets. The net inheritance to the heirs of the IRA-SUL life insurance plan is hypothetically improved by about $500,000 at joint life expectancy (20 years) with preferred medical underwriting when compared to alternative fixed financial assets.
  2. The SUL life insurance provides a guaranteed no-lapse benefit versus a non-guaranteed accumulation value of the alternative fixed financial asset. The non-guaranteed cross-over point where the non-guaranteed financial asset hypothetically exceeds the guaranteed standard underwriting SUL insurance death benefit does not occur until year 25 when the younger insured, if still alive, is age 95. The non-guaranteed cross-over point where the non-guaranteed financial asset hypothetically exceeds the guaranteed preferred underwriting SUL insurance death benefit does not occur until year 27 when the younger insured, if still alive, is age 97.
  3. The SUL life insurance could be owned by an ILIT so that the death benefit is estate tax-free for state death tax purposes. The $5,000,000 taxable estate in our case study above would generate about $300,000 of state death taxes in certain states which still uses the tax table from IRC Section 2011. Part of the SUL death benefit could be used to offset these state death taxes with the rest of the death benefit managed by the trustee for the benefit of trust beneficiaries.

The remaining IRA value at the death of the client is paid outright to children or to a separate trust for the benefit of children or grandchildren as an inherited IRA. The RMDs using the Single Life Table can be stretched over the remaining life expectancy of the children or grandchildren depending on the dispositive provisions of the trust document. Using this inherited IRA stretch method, the income taxes to the heirs are spread out and paid annually over many years into the future rather than paid in a lump sum and taxed all in one tax year.

Contact your BSMG Advisor if you have a client that has significant IRA values they never expect to use during their lifetime. Your BSMG Advisor can work with BSMG Advanced Sales to craft a plan to enhance the legacy of your client’s IRA using guaranteed no-lapse life insurance.

Russell E. Towers, JD, CLU, ChFC
Vice President, Business & Estate Planning
russ@bsmg.net