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Life Insurance: The RMD and Secure Act Solution

Life Insurance: The RMD and Secure Act Solution

February 18, 2021

I will start this article with an issue that more and more of my life-experienced clients are pondering (life-experienced sounds way better than older as this older millennial {age 55 is a millennial right?} is finding out): What do I do with my annual IRA required minimum distribution? Clearly, I have a solution for the problem or this would be a very short piece.

The idea of taking the required minimum distribution and then leaving the balance of your IRA to your children when you passed was one of the popular financial planning techniques for wealth transfer. This was due to the fact that if I am just taking the required minimum, I most likely do not have the need for any additional income from my IRA and my goal is to maximize the amount of wealth transferred to my heirs. So, I take the bare minimum out of my IRA every year planning to leave behind a large nest egg at my passing by doing so. This was great due to the concept of the stretch IRA. The stretch IRA allowed any non-spouse beneficiary to take an inherited IRA and stretch the payments out over their lifetime. By doing this the amount of income received by beneficiary over their lifetime is most likely much higher and more of that income can be received when they are in a lower tax bracket when they retire. You couple that with the fact that the IRA is continuing to grow tax-deferred and you have a pretty good deal for the non-spouse beneficiary and off you go.

Rewind to December, 2019 when Congress passes the SECURE Act. The plan allows for small businesses to be able to set-up safe harbor 401(k)s at a lower cost, changes the required minimum distribution age from 70 and ½ to age 72, allows for certain long-term part-time employees to be eligible to enroll in 401(k), withdrawals from IRA for up to $5000 for birth/adoption expenses and the elimination of the stretch IRA. An IRA inherited by a non-spouse beneficiary must be completely withdrawn within 10 years. Now that may not sound too bad, but when you assume for most non-spouse beneficiaries (i.e., children of the IRA holder) they are most likely in their high-income producing stage of life so the amount of taxes being paid on this distribution will be at their absolute highest.

So, my life-experienced client comes to me in December, 2020 and says, “Wise older millennial insurance guru what should I do now?”  I reflect momentarily and then utter the most peculiar words when it comes to IRA planning, life insurance. Now I know that there may be some of you who knew that there would be some form of insurance being mentioned, but it did take 407 words to get there so let’s focus on the positive.

Here is a hypothetical example of a man we will call Sam, who is age 72 with two grown children and his wife has predeceased him. Sam has $250,000 in his IRA currently and prior to December, 2020 was planning on leaving his IRA to children and grandchildren. Sam thinks that he can earn 6% (of course, the idea of earning 6% every year is extremely unlikely, but this is just a hypothetical example) on his IRA and is planning on just taking the RMD and investing for that his heirs as well as he has no need for any additional income that his could get from his IRA. Now for simplicity sake, I am going to assume that Sam will lose 25% of his distributions to federal taxes and 5% to state taxes so he will net 70% of all distributions. Assuming that Sam lives to his life expectancy of age 85 (which is the current estimate for a man currently age 72) his IRA will have a hypothetical balance of $254,583 after taking into account all of his distributions and interest earnings. The balance in the investment account that Sam has directed his net required minimum distributions into is hypothetically $195,052 (once again assuming the same 6% annual return). So, at age 85 Sam passes away and his children and grandchildren are remarkably in the same tax bracket as Sam (so as to make the math simple) so at his death under current tax laws Sam’s heirs would receive a net amount of $195,052 from his investment account (due to the step-up in basis allowed for in current tax code) and the $254,583 is cashed in on his death and they receive a net amount of $178,208 (70% of $254,583). The grand total that Sam passes to his heirs at his death will then total $373,260.

Now Sam could have taken annual withdrawals in the amount of $17,000 from his IRA which would give him $11,900 after taxes. He then purchases a hypothetical policy for $200,000 in a policy that he also assumes will earn a net rate of 6% on the cash value in the policy. Based on current projections when Sam dies at age 85 his hypothetical policy is projected to pay a life insurance benefit in the amount of $337,679 (which because it is life insurance is income tax-free). The IRA after the $17,000 annual withdrawals and 6% annual interest would have a value of $175,975, which after the loss of 30% to taxes nets out $123,183. So, the total that passes to Sam’s heirs then would be a total of $460,862.

So just by repositioning his assets Sam was able to increase the amount going to his heirs by over 20% while maintaining the same risk profile. Please keep in mind that this case is obviously rather simplistic and hypothetical with its constant 6% annual returns and tax rates. Keep in mind that this strategy can also work well for parents of special needs children or any situation where you are looking to try and maximize the amount of money that will pass at your death to your heirs.

Please note that this strategy is not for everyone nor I am suggesting that it is a universal solution. There a variety of factors that must be weighed in determining whether this strategy would be a good fit for you and align with your present and future goals. That being said, having this as an option may be an answer as to how most efficiently pass on your IRA asset to your non-spouse beneficiary.

For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC, nor any of its representatives may give legal or tax advice.