Do the math: what age will they likely be? Will they be in their highest earning (tax liability) years? The SECURE Act may secure the government; but it has made traditional retirement saving vehicles less than attractive options for either retirement or asset transfer. (Note: you can subscribe to the IFG newsletter and learn more about SECURE Act and other issues worth knowing).
Non-spouse beneficiaries face decisions; here are a few:
Remember, every dollar withdrawn is taxed as income. For wealthy families, the account could also face estate taxes – do you know what the law will be when this happens? And, don’t forget, some states have their own estate taxes.That double hit can strip away a big chunk of value—fast.
Wealth replacement trusts are often used by people who want their heirs to receive the full value of assets that would otherwise shrink due to estate taxes or charitable gifts. They’re especially useful for large retirement accounts, which, as I indicated, are some of the least efficient assets to leave to children or other nonspouse heirs. Estate tax exemptions are high now; but, that could change in future years – the government does like to spend and give away money for votes.
The Estate Tax Solution: An Irrevocable Life Insurance Trust (ILIT)
Many high-net-worth families use an ILIT to offset those tax losses. Here’s how it typically works:
- You take annual withdrawals from your IRA or retirement plan.
- Part of that withdrawal covers the taxes due.
- The rest funds life insurance premiums inside the ILIT.
- As long as those gifts stay under the annual gift-tax exclusion, no gift tax applies.
Why It Works
An ILIT can be surprisingly efficient. Benefits include:
- Shrinks the estate each year. Retirement account balances go down, which helps reduce future estate taxes. Keep in mind—federal exemptions are high now, but states often have their own estate tax rules.
- Tax-neutral withdrawals. The withdrawal pays for both the life insurance premium and the income tax due. Example: If the annual premium is $180,000 and you’re in a 24% tax bracket, withdrawing about $236,800 covers both the tax bill and the premium—without dipping into other assets.
- Gift-tax friendly. If structured properly, the after-tax dollars sent to the ILIT can qualify for the annual gift-tax exclusion. For couples, gift-splitting doubles the benefit.
- Estate tax protection. The ILIT itself is outside your estate, so the life insurance death benefit won’t add to your estate tax exposure.
- Tax-free death benefit. The ILIT receives the insurance proceeds tax free. Those funds can cover estate taxes and administration costs or provide liquidity for heirs.
- Flexible distributions. Beneficiaries can receive proceeds tax free, either as cash or as property purchased by the trust.
In short, wealth replacement trusts—funded through an ILIT—can turn a tax-inefficient asset (like a retirement account) into a tax-efficient legacy for your family.
Not concerned about estate taxes?
The SECURE Act is still a major issue for most everyone; and cash value permanent insurance is becoming a much more attractive option to leaving an IRA or other tax-deferred vehicle to children or grandchildren. The advantages are obvious: advanced designs can provide for enhanced cash buildup – money you can use while you’re alive, tax-free when you want it.
Also, there are no RMDs for you and no 10-year rule – and your children and grandchildren can inherit tax free money. It’s little wonder people are changing the way they think about how they locate retirement assets. Maybe you should, too.
Tell me your priorities, then schedule an introductory call! You can also subscribe to my newsletter.
