WARNING: AT THE TIME OF THIS WRITING, CONGRESS IS CONSIDERING LEGISLATION THAT, IF ENACTED, WOULD NEGATIVELY IMPACT THE STRATEGIES DISCUSSED HEREIN. BEFORE UNDERTAKING ANY SUCH TECHNIQUES, CONSULT WITH YOUR LEGAL AND TAX ADVISORS TO DETERMINE THE IMPACT UPON THESE STRATEGIES BASED UPON YOUR CIRCUMSTANCES IF THIS LEGISLATION BECOMES A PUBLIC LAW.

People own different types of assets which have different tax attributes. Following your death, your IRA may be subject to both estate tax and income tax. It may be possible to transfer more wealth to your family and, perhaps, even charitable beneficiaries following your death by using distributions from your IRA account to purchase life insurance.

Over your lifetime, you probably have accumulated many assets. You may own a home, have an investment account, have a qualified retirement plan at work or a traditional individual retirement account (IRA). 

Each type of asset has different tax attributes and understanding those attributes and how they can impact a beneficiary’s total after-tax inheritance is an important planning consideration. 

This article focuses on the tax impact of inheriting a traditional IRA and provides examples of how incorporating life insurance into your plan could help increase the amount that you pass to your heirs.

Taxes Incurred When Dying with an IRA

Qualified plans and IRAs are great ways to save for retirement. However, those accounts may not be the most tax-efficient way to transfer wealth following your death.

  • For income tax purposes, following your death, the assets in your retirement accounts are known as “income in respect of a decedent.” The assets in those accounts do not receive a so-called “step-up” in basis to fair market value when you die, and when your beneficiary receives distributions from the account, the amount of the distributions will be included in your beneficiary’s gross income and subject to ordinary income tax, not capital gains tax.
  • Also, retirement accounts will be included in your gross estate for federal estate tax purposes. Generally, if the value of your taxable estate[1] exceeds your available exclusion from the federal estate tax, the value in excess of your available estate tax exclusion (consisting in part of your retirement accounts) will be subject to a federal estate tax.[2]

When planning for what your family will receive following your death, remember that any amount they receive from your retirement accounts will be reduced by income tax and possibly federal estate tax. To state it differently, unless you specifically plan to avoid it, following your death there are always at least two beneficiaries of your retirement account, the beneficiary(ies) that you name in your beneficiary designation and the U.S. government. As a result, you might want to consider ways to reduce the tax cost of transferring a retirement account at death.

Strategies to Reduce Tax

There is more than one way to reduce the tax cost associated with passing a retirement account at death.

  • One way to reduce tax cost is to name one or more charitable organizations as beneficiaries of your retirement account. Charitable organizations qualified under IRC § 501(c)(3) generally do not pay income tax. When a charitable organization receives your retirement account, it will receive the full amount unreduced by income tax. Further, the value of your gross estate will receive a charitable deduction in the amount of the IRA account given to charity. However, leaving your retirement account entirely to a charitable organization directs that wealth (that is, what they would have received net of taxes) away from your family.
  • Another way to alleviate the otherwise full tax cost of transferring a retirement account to your family following your death, while transferring comparable or greater wealth to them, is to replace a portion of the highly taxed retirement account with the death benefit from a life insurance policy insuring your life. Generally, unless certain exceptions apply, the death benefit from a life insurance policy is not subject to federal income tax,[3] and if the policy is owned by someone other than the insured (such as an irrevocable life insurance trust) and the insured has no incidents of ownership in the policy, the death benefit will also avoid federal estate tax.[4]

Combining both charitable giving and insurance strategies can sometimes transfer the greatest amount of wealth to your family and your charitable beneficiaries while providing the best tax result for your family.[5]

Some Tax and Non-tax Planning Considerations During Your Lifetime

Before illustrating how a tax mitigation strategy using life insurance could work, a word of caution is necessary. The strategy described herein uses funds distributed from your retirement plan to pay life insurance premiums. If you will need your entire IRA to maintain your lifestyle during retirement, then this strategy should not be used. If, on the other hand, the full value of your IRA accounts is not needed to support your lifestyle in retirement, then you might consider using this strategy to reduce taxes on property transferred to your family when you die.

Also, remember that this strategy may not work when applied to your unique situation. The premium cost for a policy of life insurance is dependent upon many factors, including your age, your health and your family’s health histories, and your lifestyle (such as whether you use tobacco). 

Thus, the insurance company’s review of the factors it considers during the underwriting process may make the cost of life insurance unacceptable to you. In fact, following underwriting, your risk factors may be such that you cannot purchase life insurance at all.

Remember, too, that withdrawals from an IRA during life are subject to income tax. If you undertake this strategy, be sure that you have a plan to pay the increased income tax. If you plan to pay the tax with additional distributions from your IRA, those additional distributions will also be subject to income tax (plus an additional 10% income tax for certain withdrawals before age 59-1/2). Paying tax from distributions from your IRA will create an interrelated variable calculation in which each withdrawal to pay tax generates more tax. In that case, you could have a much larger than expected tax cost.

You should prepare a financial plan illustrating the impact of any investment strategy on your financial situation. A PNC Private BankSM wealth strategist has the tools to help prepare these illustrations.

Three Planning Alternatives

Following are three different plans that focus on what an IRA owner’s family could receive if the IRA owner passed away at different ages. These illustrations show only the income tax consequences of the plans and assume the following assumptions and conditions:

  • Unless distributed to a charitable organization (which does not pay federal income tax on its income), the value of distributions from the IRA are reduced for income tax payable on the distribution.
  • It is also assumed that the IRA owner has sufficient exclusion from the federal estate tax so that the IRA owner’s estate would not owe any federal estate tax (state estate tax laws are not considered).
  • These illustrations use hypothetical returns on investment, insurance data and tax rates. Your experience may differ. For example,
    • Your insurance pricing would be based on your personal circumstances. 
    • Your rates of return would be based on your individual investment profile. 
    • Your tax rates would be based on the amounts and types of your income, deductions you may be able to take, the state in which you live and other factors.
  • Values are shown as of the end of each year.

Before deciding whether to engage in this type of planning, you should prepare financial plans that model the results based on your individual circumstances.

Plan 1 – Stay the Course – Transfer a Taxable

Traditional IRA Account to Your Family

Plan 1 assumes an IRA owner who has attained age 63. At the beginning of the first year, the IRA has an account value of $1 million. The assets in the IRA have a gross investment return of 6.5% per year.

At age 72, the IRA owner begins receiving required minimum distributions (RMD), which are subject to income tax at an assumed rate of 40%. The net after tax amount of the RMD is added to a taxable investment account. The taxable account also has a gross investment return of 6.5% per year, 2% of which is ordinary income. Ordinary income is subject to income tax at an assumed rate of 40%. The taxable account also has a 10% turnover rate (10% of its value each year) which is subject to capital gain tax at an assumed rate of 20%. For ease of illustration (although not necessarily realistic), upon the death of the IRA owner, the assets of the IRA are subjected to income tax at an assumed rate of 40%.

Table 1 shows what could pass from the IRA to the IRA owner’s family if the IRA owner follows Plan 1 and were to die at age 65, 70, 75, 80, 85 or 90.

Table 1: Plan 1

END OF YEAR VALUES (IN DOLLARS)  NO INSURANCE - IRA TO FAMILY

Client Age Total IRA Assets IRA Less 40% Tax on IRD Taxable Acct. Value  Ins. Death Benefit Asset to Heirs
65 1,207,950  724,770  0 0 724,770 
70 1,654,996  992,997  0 0 992,997 
75 1,915,393  1,149,236  190,650  0 1,339,886 
80 2,037,737  1,222,642  541,993  0 1,764,635 
85 2,031,969  1,219,182  1,055,846  0 2,275,028 
90 1,843,980  1,106,388  1,767,921  0 2,874,309 

Plan 2 – Use Part of Each RMD to Purchase Life Insurance

Assume the same basic facts as in Plan 1, above. Alternatively, assume that when the IRA owner begins receiving RMDs at age 72, the IRA owner uses $30,000 of the annual RMD to purchase a life insurance policy on the IRA owner’s life having a death benefit of $1,025,411. (Remember that the values used in this example are illustrative only, you may not be able to purchase an insurance policy with these characteristics.) Assume that the policy is owned by someone other than the insured, such as an irrevocable life insurance trust (ILIT), so that the death benefit is not subject to federal estate tax.

Table 2 (page 4) shows what could pass to the IRA owner’s family if the IRA owner follows Plan 2 and were to die at age 65, 70, 75, 80, 85 or 90.

Table 2: Plan 2

END OF YEAR VALUES (IN DOLLARS) PURCHASE INSURANCE AT AGE 73 - IRA AND INSURANCE DEATH BENEFIT TO FAMILY

Client Age Total IRA Assets IRA Less 40% Tax on IRD Taxable Acct. Value  Death Benefit Asset to Heirs
65 1,207,950 724,770  0 0 724,770 
70 1,654,996  992,997  0 0 992,997 
75 1,915,393  1,149,236  97,279 1,025,421 2,271,936
80 2,037,737  1,222,642  268,503 1,025,421 2,516,566
85 2,031,969  1,219,182  566,358 1,025,421 2,810,960
90 1,843,980  1,106,388  1,019,405 1,025,421 3,151,215 

Plan 3 – Withdraw IRA Funds Before Required Beginning Date, Purchase Life Insurance

Assume the same basic facts as in Plan 1, above. Alternatively, assume that the IRA owner begins withdrawing $50,000 per year from the IRA at age 63 and upon attaining age 72, annually withdraws the greater of the annual RMD and $50,000. Further assume that the IRA owner uses $30,000 of each withdrawal from the IRA to purchase a life insurance policy on the IRA owner’s life having a death benefit of $2,151,468. In this example, the $30,000 annual premium purchases a larger death benefit because the IRA owner obtained the insurance 10 years earlier than in Plan 2, above. Generally, all other factors being equal, younger insureds pay lower premiums than older insureds. (Remember that the values used in this example are illustrative only, you may not be able to purchase an insurance policy with these characteristics.) Assume that the policy is owned by someone other than the insured, such as an ILIT, so that the death benefit is not subject to federal estate tax. The table below shows what could pass to the IRA owner’s family if the IRA owner follows Plan 3 and were to die at age 65, 70, 75, 80, 85 or 90.

Table 3: Plan 3

END OF YEAR VALUES (IN DOLLARS) PURCHASE INSURANCE AT AGE 63 - IRA AND INSURANCE DEATH BENEFIT TO FAMILY

Client Age Total IRA Assets IRA Less 40% Tax on IRD Taxable Acct. Value  Death Benefit Asset to Heirs
65 1,037,591 622,555 0 2,151,468 2,774,023
70 1,118,403 671,042 0 2,151,468 2,822,510
75 1,226,374 735,824 1,549 2,151,468 2,888,841
80 1,304,707 782,824 40,977 2,151,468 2,975,270
85 1,301,014 780,609 147,500 2,151,468 3,079,576
90 1,180,650 708,390 336,617 2,151,468 3,196,475

Three Plans Comparison

As illustrated in the tables above, it may be possible to pass more wealth to your family by using some of the assets in your IRA to purchase a life insurance policy. In fact, it may make sense to withdraw funds from your IRA before you are required to do so and use those funds to establish a life insurance program for the benefit of your family. Chart 1 compares the results of the three plans.

Chart 1: Using IRA Distributions to Buy Life Insurance

Chart 1

View accessible version of this chart.

Including a Charitable Beneficiary in the Wealth Plan

If your planning goals include gifts to charitable organizations, transferring the IRA to charity while replacing the IRA assets with a life insurance death benefit for your family can allow you to transfer the greatest amount to your beneficiaries in a tax-efficient manner.

Assume the facts from Plan 3, above, with the following change: The IRA owner designates a charitable organization as the beneficiary of the IRA. The table below shows what could pass to the IRA owner’s family and to charity if the IRA owner were to die at age 65, 70, 75, 80, 85 or 90.

Table 4: Plan 3

END OF YEAR VALUES (IN DOLLARS) PURCHASE INSURANCE AT AGE 63; IRA TO CHARITY; INSURANCE DEATH BENEFIT TO FAMILY

Client Age Total IRA Assets IRA Value; No Tax on IRD Taxable Acct. Value Death Benefit Assets to Charity Asset to Heirs Total to All Beneficiaries
65 1,037,591 1,037,591 0 2,151,468 1,037,591 2,151,468 3,189,059
70 1,118,403 1,118,403 0 2,151,468 1,118,403 2,151,468 3,269,871
75 1,226,374 1,226,374 1,549 2,151,468 1,226,374 2,153,017 3,379,391
80 1,304,707 1,304,707 40,977 2,151,468 1,304,707 2,192,445 3,497,153
85 1,301,014 1,301,014 147,500 2,151,468 1,301,014 2,298,968 3,599,982
90 1,180,650 1,180,650 336,617 2,151,468 1,180,650 2,488,085  3,668,735

Charitable Transfer Plan Comparison

Comparing Table 4 to the immediately preceding table shows it may be possible to achieve maximum tax savings by transferring your IRA to charity and providing for your family with life insurance. As illustrated in Chart 2, the combined value passing to charity and your family would exceed the amount were you to leave the IRA and insurance only to your family. Of course, because the IRA is passing to charity, your family would receive less than had both the insurance and IRA been left to them. Yet, by giving your IRA to charity and replacing some of that wealth for your family with a life insurance death benefit, you have removed the U.S. government as a beneficiary of your wealth.

Chart 2: Adding a Charitable Beneficiary

Chart 2

View accessible version of this chart.

Should You Do This?

Each family’s financial position and planning goals are unique, and not every planning strategy is appropriate for each family. 

Nevertheless, replacing “high tax” IRA assets with “low tax” insurance death benefits, and perhaps including charity in your plan, can be a good way to transfer greater wealth with less tax following your death.

Before engaging in any wealth transfer strategy, you should determine if it is right for you and your family. A PNC Private Bank wealth strategist can work with your legal and tax advisors to illustrate how such a strategy would apply in your individual circumstances.

If you would like to learn more about the strategy presented herein, please contact any member of your PNC Private Bank team.

 


TEXT VERSION OF CHARTS

Chart 1: Using IRA Distributions to Buy Life Insurance (view image)

Age No Insurance Assets to Heirs Buy Insurance at Age 73 Assets to Heirs Buy Insurance at Age 63 Assets to Heirs
63 639,000 639,000 2,758,518
65 724,770 724,770 2,774,023
67 822,052 822,052 2,791,608
69 932,392 932,392 2,811,554
71 1,057,542 1,057,542 2,834,178
73 1,192,626 2,188,047 2,859,837
75 1,339,886 2,271,936 2,888,841
77 1,499,850 2,363,753 2,921,068
79 1,672,990 2,463,609 2,956,441
81 1,859,721 2,571,533 2,994,827
83 2,060,337 2,687,402 3,035,985
85 2,275,028 2,810,960 3,079,576
87 2,503,992 2,941,923 3,125,231
89 2,747,268 3,079,810 3,172,441
91 3,004,979 3,224,189 3,220,712 


Chart 2: Adding a Charitable Beneficiary* (view image)

Age All Assets to Heirs Amount to Charity Amount to Heirs Total to Charity and Heirs
63 2,758,518 1,011,750 2,151,468 3,163,218
65 2,774,023 1,037,591 2,151,468 3,189,059
67 2,791,608 1,066,900 2,151,468 3,218,368
69 2,811,554 1,100,144 2,151,468 3,251,612
71 2,834,178 1,137,849 2,151,468 3,289,317
73 2,859,837 1,180,616 2,151,468 3,332,084
75 2,888,841 1,226,374 2,153,017 3,379,391
77 2,921,068 1,265,127 2,161,992 3,427,119
79 2,956,441 1,294,291 2,179,867 3,474,157
81 2,994,827 1,311,887 2,207,695 3,519,582
83 3,035,985 1,315,010 2,246,978 3,561,989
85 3,079,576 1,301,014 2,298,968 3,599,982
87 3,125,231 1,268,675 2,364,026 3,632,701
89 3,172,441 1,215,187 2,443,329 3,658,516
91 3,220,712 1,140,967 2,536,131 3,677,099

*The line difference between the line marked “All Assets to Heirs” and the line marked “Total to Charity and Heirs” demonstrates the tax savings.