As clients get older, they often express two recurring themes about their children: (1) "I don't want to be a burden to them;" and (2) "I don't want them to have any additional expenses or taxes after I die." While there may not be a lot that an independent producer can do about the former, there is something that can be done about the latter.
Tax-advantaged planning
When clients have assets to leave to their children or grandchildren, they want to pass them on as quickly and as efficiently as possible. For the vast majority of clients, estate taxes are no longer an issue, with the estate tax exemption being above $5 million.
However, most clients do not consider income taxes, which can deplete the value of property passing to their beneficiaries. Specifically, for those intending to leave Individual Retirement Accounts to the children or grandchildren, the value of the accounts could be significantly reduced by income taxes.
This effect is amplified as the beneficiaries are more likely to be in high income-tax brackets when they receive the inheritance. Additionally, the typical inheritance is received when the beneficiary is in his or her 50s — a time when earning potential and income is usually at its peak.
Beneficiaries of retirement accounts have to pay income tax on the distribution in the same way as the account holder. This is something account owners often do not understand.
While beneficiaries can "stretch" IRA distributions or defer for five years, these options are rarely selected; the favored option is to take a lump sum as quickly as possible. The only good news is that the ten percent penalty is not applicable regardless of the age of the beneficiary.
So the end result of leaving IRAs to children as a legacy is often that only part of the IRA—often 70% or less at today's income tax rates—will end up in the hands of the beneficiaries. On the other hand, if Mom or Dad are in a lower income tax bracket had taken distributions from the IRA and transferred the net funds into an asset that does not have the associated income tax liability, the value of the legacy could be increased.
The asset most commonly used is a life insurance policy with a no-lapse guarantee. No-lapse guarantee products provide clients with a guarantee of the amount of the death benefit, as long as the requisite premium has been paid. Single premiums or short-pay scenarios are used to enhance the available death benefit.
The ideal client is retired, 60 or older, has sufficient assets and income to live on, has a sufficient reserve for emergencies and wants to leave a legacy to children, grandchildren, charity or other friends and relatives. Since life insurance is involved, the client will have to be healthy enough to get life insurance and be willing to go through the underwriting process.
When looking to re-position an IRA, an important step is deciding how to structure the transaction, as withdrawals from the account will be taxable. Clients under age 59 ½ may be subject to the 10% premature distribution penalty, so this technique is generally not economic for them.
If the client does not want to pay the income tax liability in a single year, withdrawals and the resulting insurance premium can be spread over a number of years. Because required minimum distribution (RMD) amounts are variable and it is important to have sufficient funds to pay the required premium, it is generally better to set up level withdrawals over a period such as five to ten years.
If the client dies during the distribution period, the beneficiaries will inherit two assets: the life insurance and the IRA. The important planning consideration is making sure the premium paid is sufficient enough to guarantee the death benefit.
