Overview
For a long time, the game in retirement planning for income and estate tax purposes has been to maximize tax deferral while preserving the ability to payout distributions over the longest period of time possible, i.e. the so-called Stretch IRA. Truth be told, the majority of wealthy taxpayers do not need and never did need these deferred compensation assets in order to maintain their lifestyle. Congress over the years has tried to impose a combination of income and estate taxes at death upon the death of the participant to minimize the benefit of tax deferral over multiple generations.
Congress recently passed the SECURE Act. The SECURE Act, passed by the House and is awaiting Senate action. The Act is almost certain to become law in some form by the end of this year. Section 401 of the SECURE Act would change the post-death Required Minimum Distribution (RMD) rules for IRAs and other defined contribution retirement plans. Most high net worth taxpayers given the opportunity would defer retirement plans until the end of time plus ten years.
This article discusses the use of life insurance to replace lost deferral benefits as a result of the SECURE Act. When it comes to life insurance, many taxpayers attempt to think of every rationale and irrational reason for that matter, why life insurance is needed. Nevertheless, life insurance has the uncanny ability of delivering dollars at the right time and in the right amount. I have never known beneficiaries of a life insurance policy to refuse payment of a death benefit.
The Way We Were – IRA Distributions Under Current Law
My wife (hereinafter known as Mrs. Nowotny) and her high school best friend saw the movie The Way We Were around twenty times in high school. I can almost hear Barbara Streisand singing “Memories”, as I write this article!
Under present law, upon the death of a participant or IRA owner, designated beneficiaries must take distributions over their life expectancy. If there is no designated beneficiary, distributions must be made over the participant’s or IRA owner’s life expectancy as if he or she had not died if the participant had reached his or her required beginning date, or by the end of the fifth year following the participant’s or IRA owner’s death if he or she had not reached his or her required beginning date.
If the participant is survived by the spouse, the spouse may rollover the IRA to her own account and taken over the spouse’s lifetime using the Uniform Lifetime Table. If the participant is survived by children and grandchildren, and an account is created for each beneficiary no later than December 31st in the year following the participant’s death, distributions may be paid over the life expectancy of each beneficiary. If an account was not established in the manner just mentioned (December 31st in the year following the participant’s death), distributions must be made based on the life expectancy of the oldest beneficiary. For example, a forty year old beneficiary has a 42.5 year life expectancy so that distributions could be made over an additional four decades. That is a lot of tax deferral!
Required Minimum Distribution Rules After the SECURE Act
In the event the Senate passes its version of the SECURE Act, all retirement and IRA benefits will be required to be distributed within ten years of the participant’s death. The law allows for one exception for payments for Eligible Designated Beneficiaries – 1) The participant’s surviving spouse; 2) Persons with disabilities and chronic illnesses; 3) Minor children. Unfortunately, most trusts will fail to satisfy the requirements for minor children and disabled beneficiaries. Under the Act, the age to begin required minimum distributions is increased to Age 72. Unfortunately, the proposed changes also adversely impacts Roth IRAs. Benefits left to a non-spousal beneficiaries will be subject to the ten year payout requirement. If the beneficiary defers the income during that ten year period, all of the benefits become taxable at the end of the ten year period.
Life Insurance to Secure Distributions After the SECURE ACT
Additional life insurance owned within an irrevocable life insurance trust (ILIT) is an optimal vehicle to recover to offset the risk of an early death and the loss of deferral due to a ten-year payout for non-spousal beneficiaries. Life insurance preserves the post-death “stretch out” by replacing the assets that are eroded through earlier taxation as a result of the lost of the deferral period that exists under current law. The ILIT receives the death benefit income and estate tax free. The IRA or qualified retirement can make required minimum distributions which can be contributed to the ILIT in order to make premium payments. Life insurance is a method of repositioning IRA or qualified plan assets in a more tax efficient manner.
The loss of the “stretch” in the Stretch IRA makes a significant difference. For example, if a seventy year old participant without a spouse and a $5 million IRA, dies unexpectedly and names his forty year old daughter as the sole beneficiary, the required minimum distribution in Year 1 is $123, 550. Assuming an investment return of 6.5 percent per year, a forty two year life expectancy, the Plan assets have an account balance of $7.74 million at the death of the beneficiary.
Under the proposal, the plan must be distributed no later than ten years after the death of the participant, a level annual payment amount would increase significantly to $549,000 per year. Under the proposal, the participant could use the required minimum distribution to purchase a $5 million universal life insurance policy within an ILIT. The ILIT trustee would receive the death benefit income and estate tax-free. The proceeds would be reinvested and distributed to trust beneficiaries without the imposition of the mandatory ten-year payout that IRAs and qualified retirement plans would face. The Plan assets are preserved and relocation to the ILIT.
Summary
All good things must come to an end! Deferred compensation benefits – IRA and qualified retirement benefits - have been utilized by health net worth taxpayers effectively over the least several decades. While deferred compensation benefits have always been subject to income and estate taxation, the ability to “stretch” payments to beneficiaries over decades is a very powerful planning benefit.
On a certain level, life insurance agents have needed a “shot in the arm” to boost sales since the lifetime exemption was increased was increased to $11.4 million resulting in a fewer number of taxpayers being subjected to the federal estate tax. In the event the Senate passes its version of the SECURE Act, the life insurance agent version of the Plan will be called Life Insurance Full Employment Act (LIEA). Just kidding! Life insurance is not the only “fix” to the problem but perhaps one of the best.
A lot of excellent estate planning attorneys and CPAs made a good living advising clients on how to implement and utilize the Stretch IRA. The Grim Reaper is knocking on the door. The Stretch IRA is about to be eliminated. Not to worry! Life insurance will allow plan participants to preserve and relocate plan assets in a tax efficient manner for future generations.
