It’s not uncommon for clients to invest in retirement vehicles without a complete understanding of the long-term tax implications. While they may benefit from the tax-deferred status of these investments, there’s typically little said about the Income tax consequences that will take place when these assets are sold after the client passes.
As President Biden advocates for higher taxes on inheritances, you may have more clients searching for a way to minimize their overall tax liabilities, so a greater legacy is passed on to their heirs. Higher income tax rates applied to greater gains increase the liability to the IRS and not to the desired beneficiaries. We call these the hidden taxes of dying.
Fortunately, life insurance is a tax planning vehicle that when efficiently implemented, will offset the taxation of the deferred tax liabilities associated with certain asset classes. There are three deferred tax areas where the use of life insurance will benefit your clients and their heirs. They are planning for tax deferred annuities, tax qualified accounts (IRA’s, 401k’s & Pension and Profit-Sharing Plans) and capital gains tax to be incurred on low basis and previously gifted assets. Let’s take a closer look at each.
You may have clients who purchased annuities earlier in life. They were designed as an efficient way to save for retirement, and/or grow their investment dollars in a tax deferred environment. In the future when these dollars may no longer be needed for current spending and the planning goals have changed, forethought for tax efficient distribution must be addressed.
Unfortunately, the deferred gains earned within the annuity will now become both income taxed upon their demise, and the entire annuity will be subjected to estate taxation. Other than a tax “qualified account”, the annuity will be their most taxed asset at death.
This is where a creative but conservative life insurance strategy will work wonders, but only if your client is insurable. By using section 1035 of the code, the tax deferred annuity can be moved to a new carrier that will issue a single premium immediate annuity (SPIA) and we will select the carrier that will provide the greatest annual payment for the life of your client. The annual payout would then be gifted to an irrevocable trust where the client can purchase life insurance.
This strategy eliminates both the estate tax on the annuity and the deferred income taxation of the annuity gains when the life insurance is paid at death, whether outright or in trust. It is our experience that this strategy standing alone doubles the annuity legacy that would have taken place without additional planning.
This simple rearrangement of assets will create a much more aligned result.
IRAs and Pension Plans
An IRA or pension plan is generally viewed as a savings account that grows tax-deferred for retirement. What most people don’t talk about is that one day your client will have to pay taxes on the money that has accumulated. When your client starts taking required minimum distributions (RMDs), taxes must be paid on those withdrawals. However, with regards to the RMDs, the rules have, and are planning to be changed again. The SECURE Act of 2019 increased the age from 70½ to 72. Today, the SECURE 2.0 Act of 2022 is now delaying the RMD age from 72 to 73 starting in 2023, and then again to age 75 in 2033. At death, there is no step-up in basis as there would be with a stock that is owned personally and appreciates outside a retirement account. That means the beneficiaries must pay income taxes on any and all distributions after the client dies, plus possible estate taxes. Even more egregious are the recent changes to the inherited IRA distributions rules that require complete distribution within a few short years.
There are two planning alternatives:
For those who can roll an IRA account into a Qualified Plan – Much like the annuity mentioned above, your client may no longer need or want the income from an IRA. Many of our clients have operating business entities that were created to support their estate plans. The implementation of certain estate planning entities also allows for the creation of a “qualified plan” where this strategy can take place.
If the fact pattern permits, the IRA account can be “rolled” into a qualified plan where life insurance can be purchased within the plan using “seasoned funds” to pay the premiums. Once the insurance is in place, the qualified plan can now sell the policy to an irrevocable grantor trust. Using this strategy, the death benefit is paid without estate taxation. Upon the client’s passing, assets are then distributed from the Trust based upon designs that are indigenous to the family situation. This may include generation skipping strategies that could not take place without additional planning.
For those who cannot roll their IRA account into a Qualified Plan –
Life insurance is still an option if your client has only an IRA and can’t move funds back to a qualified plan. They can take the after-tax distributions and use the proceeds to purchase life insurance outside the estate. When comparing this strategy to merely growing the IRA, taking RMD’s and taxing the balance at death, the client and family will enjoy the following;
- A net inheritance that will be far more than the current plan.
- Minimal restrictions on the distribution of this asset to succeeding generations. The funds will be inherited within an irrevocable trust that can be distributed without the limitations surrounding IRA accounts.
Of course, neither of these strategies are available to those who wait too long and are uninsurable.
Assets held until death traditionally enjoy a “Stepped Up” income tax basis. Unfortunately to enjoy this “Step Up”, the asset will be held in the client’s taxable estate creating estate taxation. Historically, the estate tax rate is higher as compared to the capital gains tax rate and as such, becomes the most important tax to plan for. Unlike a sale, the estate creator merely passed away without the resulting liquidity event a sale transaction would have.
The first step in advanced estate planning is to remove assets that are appreciating from the estate using a leveraged gifting strategy. As these assets are removed from the taxable estate, their income tax basis remains the same as when it was originally gifted. Although we have removed the asset from estate taxation when the asset is ultimately sold, capital gains taxation will arise.
We are avoiding one tax at the expense of another. This may be a better strategy for your client than merely passing down assets to heirs in a taxable estate at death. In either case however, it’s important to remember that the capital gains tax is a hidden tax that will take place somewhere down the road.
Again, this is where life insurance can be a useful vehicle. It can be used to replace the capital gains tax upon sale of the appreciated asset.
It’s not unrealistic to think that you may have a client dealing with a combination of all three scenarios. If that’s the case, life insurance, combined with these traditional strategies, could be a way to address the issue of deferred or hidden taxes they will likely face down the road. It’s best to think ahead. Please call us if you would like to discuss these strategies in greater detail.
About the Author
Richard K Newman
Richard is a well-known life insurance expert who works with CPAs, attorneys, Registered Investment Advisors and nonprofits. For more than 35 years, he has guided clients with their estate planning, wealth transfer and tax-related matters.