The Baby Boomers over the next 20 years will transfer more wealth than this country has ever seen. Much of it, $7 trillion to be exact, is accumulating in tax-deferred accounts like IRAs and 401(k)s.
The key word here is tax-deferred, not tax free. No matter what you do, either you or your heirs will have to pay taxes on that money some day.
While these qualified assets are accumulating tax-deferred during your client's lifetime, the tax burden they are leaving their children is growing as well. In this article series we're going to introduce three wealth transfer solutions specifically designed to alleviate the tax burden on qualified accounts like IRAs and 401(k)s.
Strategy No. 1involved leveraging RMDs to Offset Income Taxes.
Strategy No. 2 involved leveraging a charitable donation to Eliminate Income Taxes.
Summary: Your client has a significant amount of money in an IRA. He is taking RMDs, but he doesn't need them for income. He would like to leave the IRA to his beneficiaries, but he wants to make sure he’s maximizing the potential payout not only his children receive, but also his grandchildren. In this concept you have the client do a Stretch IRA and use the unwanted RMDs to fund a survivorship life insurance policy, naming his children as the beneficiaries.
Here is the way most IRA distributions plans work. The spouse is designated as the primary beneficiary. So when the IRA owner dies the spouse does an IRA rollover into his or her own account, continuing the tax deferral and taking the RMDs. Typically, the children then become the beneficiaries.
When the children eventually inherit the IRA, the number of years they can defer the taxes is based on their age at the time. If the children pass away before the end of their maximum deferral period, their beneficiaries—typically the grandchildren of the original IRA owner—inherit the balance of the funds and the balance of the deceased child’s deferral period.
For example, if the child had a maximum deferral period of 25 years and they die 20 years in, their beneficiary will only be able to defer taxes for the remaining five years.
Figure 1: Standard IRA Distribution
By making some simple changes to their IRA beneficiary designations, your clients would be able to base the maximum deferral period on the grandchildren's life expectancy, rather than their children’s, dramatically increasing the years of tax deferral and the total benefit.
Step 1: Determine the projected value of the IRA at a point in the future when the surviving spouse expects to transfer the IRA to his or her grandchildren.
There are varying degrees of detail you can go into here. You can purchase a life expectancy calculator that will take into account a variety of criteria to give the most accurate prediction. You can use a free calculator like the one at www.livingto100.com, which takes into account lifestyle factors, nutrition, body type and medical factors to give a life expectancy. Or you and your client can just select an age like 80, 85 or 90 for illustrative purposes.
In this case, let's say the client's life expectancy is 85. You will illustrate the IRA value at age 85 (taking into account the 6% growth rate and the RMDs) to be $1,124,385.
Step 2: Purchase a life insurance policy
The client will use all or part of his RMDs to purchase a survivorship or "second-to-die" life insurance policy, naming a loved one as beneficiary with a face amount equal to the projected value of the IRA at age 85: $1,124,385.
Now, instead of an IRA they would have had to pay income taxes on, they receive a death benefit that is income-tax free.
We recommend NACOLAH's Survivorship GIUL.
See an Illustration for this case using Survivorship GIUL.
Step 3: Change the designated beneficiary on the IRA from the children to the grandchildren
Remember, while both spouses are still alive, the beneficiary remains the spouse. It is only after the IRA has transferred from the IRA owner to the surviving spouse that the grandchildren become the beneficiaries.
Figure 2: Multi-Generation IRA Distribution
By doing the Stretch IRA distribution, you can actually increase the projected distribution on your client's $1 million IRA from $3,710,145 to $12,263,120!