“It doesn’t matter how much you make, but how much you keep.” Over time, taxes can be a significant drag on returns, especially for those who are in the higher tax brackets. Today, many families are also hit with the 3.8% Medicare surtax on investment income. If you are in the top tax bracket, you could be paying as much as 43.4% (39.6% plus the 3.8% Medicare surtax) for interest income or short-term capital gains.
For several years, there has been a proposal in Washington to eliminate the Stretch IRA, also known as the “Inherited IRA” or “Beneficiary IRA”. Currently, when your beneficiary inherits your IRA, they can keep the account tax-deferred by leaving the assets in a Stretch IRA. While they have to take Required Minimum Distributions, using a Stretch IRA keeps distributions small and taxes low, as well as encourages beneficiaries to use the money gradually rather than spend their inheritance immediately.
Congress is looking for new ways to reduce the budget deficit, and according to IRA expert Ed Slott, it is increasingly probable that the Stretch IRA will be eliminated in the near future. Forcing beneficiaries to withdraw their inherited IRAs will raise billions in tax revenue, while allowing politicians to say that they haven’t raised tax rates.
If the Stretch IRA is repealed, beneficiaries will have to withdraw all of an inherited IRA – and pay taxes on the distributions – within five years. For many retirees, their retirement accounts are their largest assets. Many have accumulated a significant sum, often $1 million or more. If your beneficiary receives a $1 million IRA in one year, regardless of whether they spend the money or invest it, they could owe up to $396,000 in income tax. Even spreading the withdrawal over five years ($200,000 a year) will push any tax payer into a high tax bracket where the IRS will collect 28%, 33%, or more from your IRA.
If you aren’t touching your IRAs because you have other sources of retirement income, such as a pension, Social Security, or other investments, you may have been thinking that you would leave the IRA to your heirs and not take any withdrawals. It’s a very generous plan, but if the Stretch IRA is repealed, a significant amount of your IRA is going to end up in the pockets of the IRS.
What can you do to minimize the taxes and maximize the amount your heirs will receive? Here are three ways to accomplish this:
1) Buy life insurance. Use your IRA money to fund a permanent life insurance policy, such as a level premium Universal Life policy. Life insurance death benefits are received income tax-free. Purchase a $1 million policy for your beneficiaries and they will receive all $1 million tax-free.
For example, a healthy 65-year old male can purchase a $1 million Universal Life policy for as little as $17,218 per year. That is a sizable premium, but not a bad deal to guarantee your heirs a $1 million payout, tax-free. While funding those premiums from your IRA does create taxes, the taxes paid will be lower if you take small withdrawals over a period of many years rather than leaving your heirs in a position of having to take the entire distribution over 5 years (or 1 year if they don’t do the distribution correctly).
If you don’t need the income from your RMDs, using those distributions to fund a life insurance policy may have a significant benefit for your heirs.
2) Leave to Charity. There is a way to pay no tax on your IRA on death and that is to leave the account to a charity. 501(c)(3) non-profit organizations will not have to pay any income tax when they are named as the beneficiary of your IRA or retirement accounts. If you were planning to leave something to charity, make sure that bequest is from your IRA and not from a regular account.
Scenario 1: You leave a $1 million taxable account to charity and a $1 million IRA to your daughter. The charity receives $1 million, but your daughter will owe taxes up to $396,000 on the IRA, leaving her with as little as $604,000.
Scenario 2: You leave the $1 million taxable account to your daughter and the $1 million IRA to the charity. The charity receives $1 million, your daughter receives $1 million (and a step-up in cost basis), and the IRS gets zip. Much better!
3) Spread out your IRA. If you leave $1 million to one beneficiary, they will have to pay tax on the entire amount. If you leave the IRA to 10 beneficiaries (perhaps grandchildren, nieces, nephews, etc.), the tax due will be much less on $100,000 for 10 tax payers than on $1 million received by one person.
Please note that spouses can roll their deceased spouse’s IRA into their own IRA and treat it as their own. If the Stretch IRA is repealed, this may not be a problem for leaving an IRA to your spouse. However, if your spouse consolidates both of your IRAs into one account, the tax problem for the subsequent heirs will have become even more significant.
The one good thing about IRAs is that you can change your beneficiaries at any time without having to re-do your Will and other documents in your Estate Plan. It is very important to remember that your IRA beneficiary designations override any instructions in your Will, so it is vital to have your beneficiary designations correct and up-to-date.
Not sure where to begin with your Estate Plan? We can help you find the right solution for your family, using our Good Life Wealth planning process. Interested in finding out more about life insurance? I’m an independent agent and can help you choose the best insurance policy for your goals. Call me with your questions, reducing taxes is my passion!
Life insurance isn’t for you – you really purchase life insurance to protect someone else. If you have a spouse, children, parents, or even a business that is depending on your future work and income then you should consider if a life insurance policy makes sense for you. Life insurance is an essential piece in the financial planning process that is often overlooked by many young families. It is not always easy to discuss the reality of our own mortality, but most people feel more secure once they have a life insurance policy in place.
Life Insurance premiums are based on your age and health, so the best time to get a policy is when you are young and healthy; you will be able to get the best price from an insurer and lock in your cost and coverage. If you later develop health issues, such as diabetes, high blood pressure, or a more serious condition, you may find that you are now uninsurable or that adequate coverage is prohibitively expensive.
A young professional is probably not thinking about life insurance, but with decades of earnings ahead of them, actually has the greatest amount of future income that would require replacing in the event of their unexpectedly passing. An older individual, say with grown children, does not have the same liabilities or as many years of future income that would require replacing for their family.
As a Financial Planner, my recommendation is to use Term Life insurance for young families. Many individuals can buy a policy for under $1000 a year and that may be the last policy they will ever need to own. With Term Life, you lock in a low cost that is guaranteed to not increase over the life of the policy. We look at 15, 20, and 30 year policies and try to match the duration of your future needs, as well as to make sure that the policy will be in force through your children’s college years. To decide on a benefit amount, we look at a number of factors including your income, liabilities, and children’s needs. However, as a rule of thumb, a benefit of 8-12 times your annual income is often adequate. Rather than thinking about life insurance in terms of mortality, it helps to frame the conversation around looking at your family’s potential need for income replacement.
You may hear about other types of life insurance, but insurance is not the most efficient tool for investing, so I typically steer clients away from policies that have a cash value or are used as an investment vehicle. “Buy Term and Invest the Difference” is my approach and the philosophy embraced by many financial professionals. In planning for clients for a period of decades, our goal is for them to become self-insured by their 50’s, so that they have enough in assets that life insurance is not a necessity. When their Term Life insurance policy reaches the end of its term period, they may not need to purchase another policy.
There are some reasons to buy a permanent policy, such as Universal Life or Whole Life, if you have a specific requirement to leave money at your passing. This might be for charitable purposes, for business requirements, to fund a special needs trust, or to pay for estate taxes. Outside of very specific needs like these, most individuals will be well served with a term policy instead.
Two other thoughts on buying life insurance:
1) Don’t rely on a group life policy with your employer. Employer life insurance benefits are generally not portable if you change jobs, do not have fixed premiums, and may be dropped if your company amends their benefit programs. You’re not in control with a group policy. If you are in relatively good health, buying an individual policy is typically a better solution. However, if you have some health concerns, a group policy may be affordable and the only coverage you can obtain.
2) Term Life is largely a “commodity” product today, so it pays to shop around or use an independent agent, such as myself, who can get quotes from multiple companies. Each year, when I send in my check for $350 for my annual premium, I think how glad I am to have my term policy in place. Term insurance can be incredibly cheap for a significant amount of coverage.
I hope that none of my clients will ever need to make a claim on their Term Life policies, but I have to say that it has been very satisfying to know that I have protected quite a few families over the past 10 years with this vital program. It may not be the most interesting or significant part of a financial plan, but if a claim did occur, it would be the only part of the plan that mattered. If life insurance is something that you haven’t gotten around to, please give me a call, and we will get it done for you. And your spouse will sleep easier, rather than wondering, What if?