Transition IRAs To Life Insurance
IRAs would be transitioned to life insurance by taking lifetime taxable distributions over time (beginning even before RMDs begin) and taking advantage of the lower tax brackets over several years, minimizing the taxes.
Advisors should take full advantage of the IRA “sweet spot.” This is the period between ages 59½ and 70½ (or maybe even age 72, which is proposed under the SECURE Act). During this time RMDs are not yet required and distributions are not subject to early distribution penalties. This allows the maximum flexibility for distribution planning. Funds distributed from an IRA can be invested in life insurance that can be left to a trust, instead of leaving the IRA to the trust. This can avoid dealing with the IRA trust problems outlined above that will be created under the proposal.
Life insurance is a much more flexible and tax-efficient asset to leave to a trust since unlike IRAs, there are no complex trust rules, no RMDs, no IRA custodial issues and the life insurance that will be paid to the trust will be tax free. The trust could be set up to simulate the stretch IRA without worrying about life expectancy tables or types of beneficiaries. The trust can be customized to whatever level of protection and control the client desires. Life insurance can provide the two big estate planning benefits—post-death control and no trust tax problems. This will be the solution most will use going forward to replace large IRAs, or even smaller ones where control might be desired.
5. Charitable Trusts
This is another potential solution if the client is charitably inclined. IRA funds would be left to a CRT (charitable remainder trust) that would pay annual income to the beneficiaries for a term of years or for life – similar to a stretch IRA. The payments would be taxable based on the tax tier rules of IRC Section 664(b) where the first funds out would be taxable as ordinary income, then capital gains, tax-exempt and lastly, tax-free return of principal.
The IRA distribution to the CRT would be income tax free, so all of the inherited IRA funds would be earning income. The downside here is that after the beneficiary dies the funds go to the charity. The beneficiary would have to live at least an average life expectancy to match the amount that he would have received if he inherited the IRA directly. If the beneficiary dies early, there is no successor who can continue the payments. The remaining balance would belong to the charity. In addition, there would be no lump-sum payment options, say if the beneficiary needed to dip in to the funds or needed a larger amount of money than the annual payments from the CRT, but then again, the client may want that protection. There would also be trust tax returns and administration costs each year. The CRT would only be worth it for large IRAs where there is a charitable intent.
Bottom Line For Financial Advisors—Get Busy!
Advisors need to get busy identifying the clients who will be most affected and begin having conversations about providing solutions. The top target will be the largest IRAs and specifically those IRAs currently being left to IRA trusts. These plans will no longer work as well as under the current rules, and may not work at all. Life insurance would be a better solution in addition to lifetime beneficiary and ongoing tax-bracket planning. Whether or not the law changes, clients need stable long-term estate plans for their retirement savings. That planning needs to begin now.
Ed Slott, CPA, is a recognized retirement tax expert and author of many retirement-focused books. For more information on Ed Slott, Ed Slott’s 2-Day IRA Workshop and Ed Slott’s Elite IRA Advisor Group, please visit www.IRAhelp.com.