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Using Life Insurance to Protect IRA Values
By Marvin Rotenberg, IRA Technical Expert
Life insurance is not only the single biggest benefit in the tax code, but it is also the most cost effective way to protect a large-balance IRA. Many owners of large-balance IRAs are concerned about protecting IRA values during volatile markets. Life insurance proceeds can do just that with its incredible leverage.
Life insurance proceeds are, with few exceptions, free of all income tax. Life insurance can also be exempt from federal estate tax when structured properly. If the insured has any rights or powers over the policy (so called, “incidents of ownership”), the proceeds will be included in his or her estate and be subject to federal estate tax and potentially state estate tax as well. In order to avoid estate tax on the proceeds, many individuals have their life insurance policies owned by a spouse, children, or others. In these cases, the policy proceeds are paid to the owner’s beneficiaries free of federal and state estate tax.
However, problems can arise when another person owns your life insurance policy. With full ownership rights, this person could make whatever changes he or she desired to the policy, such as changing the beneficiary or canceling it prematurely. To avoid these problems, the policy can be purchased by, or transferred to, an irrevocable life insurance trust (ILIIT) so that it will not be included in your estate. Of course, in order for this to work you cannot be a trustee or beneficiary of the trust because being either would represent an incident of ownership on your part.
If finding the money to pay the premiums will cause you a financial hardship, consider withdrawing funds from the IRA to make those premium payments. After age 70 ½, mandatory withdrawals from a traditional IRA must begin anyway. Since the money will have to be withdrawn, it may as well be leveraged to pay the life insurance premiums. This works even better with a Roth IRA as you probably won’t have to worry about paying any income tax on the distributions.
As far as the actual payment of the policy premiums is concerned, it should be done by the beneficiaries or by the trustee of an ILIT so that the life insurance proceeds will be estate tax free. The premium payment money may come from you making tax-free gifts either to the beneficiaries or to the trust. You should not make the payments directly to the insurance company.
After the IRA owner’s death, the life insurance proceeds will be available to pay the estate tax or provide other liquidity so that the IRA assets won't have to be used. The idea behind all of this is to keep as much of the IRA money intact as possible at the IRA owner’s death so that the maximum amount is available to be stretched by the beneficiaries. And what if there is no estate tax to be paid? Your beneficiaries receive an income tax- and estate tax-free payout. I don’t think they will complain about that.