Life insurance has been an important estate planning tool that can lessen the estate tax burden on individuals and their beneficiaries. With the passage of the SECURE Act, life insurance becomes an even more important planning resource to consider. That’s because one of the key components of the recently passed SECURE Act is the change in how IRA — both traditional and Roth — and qualified plan distributions must be handled when inherited by nonspousal beneficiaries.
These distributions have always been subject to income taxes, and that hasn’t changed with the SECURE Act. What has changed is the required timing of those distributions by nonspousal beneficiaries and the higher income taxes likely to result.
Let’s unpack this a bit: Prior to the SECURE Act, nonspousal beneficiaries were permitted to minimize distributions — and therefore minimize taxable income and income taxes. This was accomplished by distributing the assets over the full life expectancy of each beneficiary. In some cases that would mean distributing the assets over many decades.
Life insurance may help counter the higher taxes associated with the SECURE Act’s new distribution rules and allow beneficiaries to optimize after-tax amounts.
Now, although with some exceptions, the SECURE Act will require nonspousal beneficiaries of qualified plan and IRA assets to distribute balances within 10 years of the owner’s death. Since the distributions will occur over a much shorter period, the probability is high that they’ll be taxed at higher marginal rates, resulting in materially smaller after-tax amounts received by beneficiaries.
Life insurance is income-tax-free and also can be estate-tax-free, so individuals would be wise to consider using it as a planning vehicle. In other words, life insurance may help counter the higher taxes associated with the SECURE Act’s new distribution rules and allow beneficiaries to optimize after-tax amounts.
Consider the following strategy:
- Assuming the IRA/qualified plan owner is taking required minimum distributions (RMDs) annually, the owner could take the after-tax amount of the RMDs and use them to purchase a permanent life insurance policy.
- At the owner’s death, the beneficiary would receive the death benefit income-tax-free by the beneficiary. Instead of receiving IRA and/or qualified plan assets that must be distributed and taxed within 10 years, beneficiaries would get the full value of the income-tax-free death benefit.
- If the life insurance purchase is structured so that the policy is owned by an irrevocable trust, the death benefit also can be estate-tax-free.
Now that most provisions of the SECURE Act have gone into effect, individuals may want to take a closer look at life insurance as an additional planning opportunity. As with any planning strategy, you should discuss the many details and nuances with your advisors and carefully weigh the options.
Have questions about how the SECURE Act will impact IRA and qualified plan distributions? Feel free to give us a call.