Life insurance used to be an essential element of most estate plans, but it hasn’t been for about 20 years.
Important changes, however, make it time for many people to give serious thought to including life insurance in their estate plans.
In this article, I’m talking about permanent life insurance, not term life insurance.
There’s a place for term insurance in financial plans, but today we’re going to look at how permanent life insurance improves estate plans and retirement plans – including the 7 ways listed below.
First off, keep in mind that the substantial increases in the lifetime estate and gift tax exemption (in the 2001 tax law and again in the 2017 law) meant fewer and fewer people had to worry about how their federal estate taxes would be paid.
That made permanent life insurance less important. But there’s a real possibility the estate tax exemption will be reduced in the coming years, either by an act of Congress or when the 2017 tax law expires after 2025.
More importantly, inherited traditional IRAs and 401(k)s always have been heavily taxed assets, and those taxes are increasing.
That trend began with the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019, which eliminated the Stretch IRA. More taxes and restrictions on traditional retirement accounts are in the queue in Congress with bipartisan support.
Life insurance can help reduce those taxes and increase the after-tax wealth of you and your heirs.
Here are 7 reasons to consider including life insurance in your estate plan, especially as a strategy to reposition traditional IRAs and 401(k)s.
1. Life insurance benefits are tax-free to beneficiaries
They are one of the few tax-free assets and forms of income in the tax code and one of the longest-established tax-free assets.
By contrast, after traditional IRAs and 401(k)s are inherited, the beneficiaries pay taxes at their ordinary income tax rates on the distributions they take.
2. The beneficiaries only inherit the after-tax value of retirement accounts
The SECURE Act potentially increases taxes on inherited IRAs by requiring the accounts to be distributed within 10 years.
The beneficiary pays taxes faster than in the past, and because the distributions can’t be spread over a longer period, it’s more likely the income will be bunched into a few years and push the beneficiary into a higher tax bracket.
3. The longer you keep wealth in a traditional IRA, the more likely it is to appreciate
The appreciation increases future income taxes.
Also, required minimum distributions (RMDs) must be taken from a traditional IRA by the owner after age 72.
You have less control over your future income taxes and the amount your beneficiaries will inherit because of the RMDs.
Of course, income tax rates seem likely to rise in the future because of the federal budget situation and the push in Congress for higher spending.
4. The longer money stays in a traditional IRA, the higher the future taxes on distributions are likely to be
With permanent life insurance, the minimum amount your beneficiaries will receive is guaranteed.
It isn’t subject to market fluctuations the way IRA investments are.
In addition, life insurance benefits might increase over time, depending on the type of policy you select.
5. Permanent life insurance also can provide tax-free cash during your retirement years
In most policies, some cash can be taken as tax-free distributions from the cost basis of the policy, and additional cash can be taken as loans of the policy benefits.
The loans are both tax-free and penalty-free. They don’t need to be paid back, though outstanding loans will reduce the benefit paid to heirs.
Insurance policy cash distributions and loans also won’t trigger the Stealth Taxes, such as taxes on Social Security benefits and the Medicare premium surtax.
The life insurance benefits also can avoid the federal estate tax without using part of your lifetime estate and gift tax exemption.
To do this, you can’t own the insurance policy.
It must be owned by an irrevocable trust or other independent entity, and that could limit your ability to take lifetime cash distributions or loans.
6. Repositioning a traditional IRA or 401(k) as permanent life insurance also creates leverage for your retirement plan
A dollar deposited in the insurance policy results in more than one dollar in life insurance benefits.
The extent of the leverage depends on your age and the type of policy you choose. But in most cases, the life insurance benefits are going to equal or exceed the pre-tax value of the traditional IRA balance and exceed its after-tax value.
Often, it would take years of steady investment returns for the after-tax value of a traditional IRA to exceed the life insurance benefits.
Plus, the life insurance benefits would be guaranteed and tax free, two qualities the traditional IRA won’t have, and could have the potential to increase.
Permanent life insurance traditionally was used in estate plans to pay estate taxes or debts, and still can be used that way.
They also can be used to ensure an inheritance so the rest of your assets can be spent during retirement and will be available to pay for any long-term care needs.
But today, converting all or part of a traditional IRA to permanent life insurance should be explored if you have a substantial IRA, plus other income and assets to fund retirement.
7. All of the IRA isn’t needed to ensure retirement security
Often in these situations, the IRA primarily is intended to be inherited by heirs and secondarily is a source of emergency cash for the owner.
Of course, other assets also can be converted to permanent life insurance and will generate benefits.
But traditional IRAs and 401(k)s are especially ripe for being re-positioned as life insurance, because there’s a heavy tax burden on the IRAs and that burden is likely to increase over the years.
Because the SECURE Act also applies to Roth IRAs, it might be beneficial to reposition a Roth IRA as life insurance.
One strategy is to take annual distributions from a traditional IRA, either as RMDs or before RMDs begin. Some people take more than the RMDs.
Use the after-tax distributions to pay annual premiums on a permanent life insurance policy. Another strategy is to take a larger distribution from the IRA. Some people take a distribution of the entire traditional IRA, though this could push them into the highest income tax bracket for the year.
Others take the maximum lump sum they can without pushing them into the next higher income tax bracket.
Then, the after-tax value of the distribution is used to make a lump-sum deposit on a permanent life insurance policy.
This can be done one time or each year for a period of years.
Congress changed the rules on IRAs several times and more changes are planned.
Many IRA owners need to change their strategies to reduce or eliminate those taxes, creating higher after-tax wealth for themselves and their families.