This plan can be taken a step further if the client is interested in leaving a portion of his or her estate to grandchildren or great grandchildren, who may be in even lower income tax brackets than the children (that amount is subject, of course, to the Kiddie Tax). True, it’s no longer possible to defer IRA income tax over the lives of these later generations. But that does not mean it isn’t helpful to distribute to grandchildren or great grandchildren (a group that’s usually larger than the second generation, requiring income to be spread over more taxpayers). It’s still a beneficial income tax planning technique because of the lower overall income taxes that often result.
Finally, a client will want to first make any charitable gift out of the IRA portion of the estate.
3. Withdrawing additional IRA funds early and using the after-tax amount to purchase income-tax-free life or long-term-care insurance. This option is intended to combine the first two options, but rather than withdrawing all or most of the IRA funds early, the technique merely “freezes” the current value of the IRA since the client withdraws only the account growth or the required minimum distribution, whichever is greater, hopefully without increasing the account owner’s income tax bracket. All or a portion of the after-tax withdrawals are then reinvested in income-tax-free life insurance, including so-called second-to-die life insurance that pays only at the death of both spouses and is therefore cheaper than an individual policy insuring only one spouse.
The life insurance can then be left to the beneficiaries in the higher income tax brackets, while the rest of the IRA goes to those in the lower tax brackets, including, if desired, grandchildren and great grandchildren (again, of course with any adjustments desired to account for the disparate income tax treatment of the beneficiaries and with due regard for the Kiddie Tax).
Another option is to use the after-tax withdrawn funds to purchase long-term-care insurance (including a hybrid life/long-term-care insurance policy) in order to protect the portion of the IRA that has not been withdrawn and potentially create an income tax deduction for premiums paid on a traditional long-term-care insurance policy (including a so-called “partnership program” traditional long-term-care insurance policy).
4. Paying IRA benefits to an income-tax-exempt charitable remainder trust. This alternative technique involves designating an income-tax-exempt charitable remainder trust as the beneficiary of the IRA proceeds. Assume, for example, that a $100 IRA is made payable to a charitable remainder unitrust that pays the owner’s three children (ages 60, 58 and 56)—or pays the survivors or survivors of them—7.5% of the value of the trust corpus (determined annually) each year, until the last of the three children dies. Assume this takes 30 years, and that the trust grows at the same 7.5% annual rate throughout the 30 years. Under this plan, the owner’s children will receive a total of $7.5 a year (or $5 after an assumed 33.3% combined federal and state ordinary income tax rate), which when then compounded outside of the trust, at a rate of 6% after a 20% capital gains tax rate, will equal almost $400 in 30 years. The charity will receive the $100 principal at the end of the 30 years, and the trust meets the requirements of a qualified charitable remainder unitrust.
This sounds good, but compare this alternative to the one of doing no planning under the new tax law. The $100 IRA would grow to $206 10 years after the owner’s death. If we assume that there’s a 40% tax rate on this amount compressed during the children’s peak earning years, this would net them $124 10 years after the owner’s death. Next assume this amount grows at a 7.5% rate (or 6% net of an assumed 20% capital gains tax rate) for the next 20 years. Just as they would in the charitable trust alternative, the children would net almost $400. The difference is that charity does not receive $100 under this no-planning scenario. Perhaps more significantly, however, under the no-planning alternative the entirety of the IRA funds is available to the children, at all times, whereas under the charitable remainder trust alternative the principal of the trust may not be accessed until paid out to the children according to the designated schedule.