If you’re close to or in retirement and asking yourself how you can best pass your wealth on to your heirs, repositioning some of your investments may be a tax-efficient way to leave a larger financial legacy.
You’ve worked hard to build up your nest egg and find yourself in a position where you can enjoy a comfortable retirement and also leave a legacy.
Your goal may be to pass more of your wealth on to your beneficiaries and less to the IRS. Using an asset-repositioning strategy to another vehicle, such as a life insurance policy, may be a way to help you do it.
How does asset-repositioning work?
When you apply this strategy, you exchange one of your existing investments for life insurance, which may be more tax efficient, depending on your circumstances. Let’s look at a few strategies one could consider using for this strategy.
An assumption most investment professionals use is that, over time, more conservative, or short-term, investments will typically return less than more aggressive, or longer-term holdings. (There are periods during which this assumption may not hold.)
By repositioning a portion of your lower-yielding securities into life insurance, you could possibly help your heirs receive a larger inheritance. Here’s an example of how the strategy works: Money market & CD yields in 2021 have been approximately
1%. If these lower-yielding dollars were repositioned into life insurance, the leveraged tax-free gain would likely be higher than the current yield on short-term investments.
Required minimum distributions (RMDs) from retirement assets
Once you reach age 72, the IRS mandates that you start taking distributions from any of your Individual Retirement Accounts (IRAs), or be subject to a 50% penalty. Many people use their RMDs to pay for living expenses. However, if you don’t
need (or want) this excess income, the asset-repositioning strategy could prove to be beneficial if your goal is to leave a legacy.
You can repurpose the RMDs, and use the distributions to pay life insurance premiums. This can be especially beneficial in light of the recently passed Secure Act. After January 1, 2020, most "non-spousal” beneficiaries must now take full distribution of the Inherited IRA within 10 years. This means that the entire balance of the IRA is fully taxable (at the beneficiary’s tax bracket) within 10 years. This new IRS ruling can place a large unintended tax burden on the IRA holder’s heirs. Tax-free life insurance proceeds could possibly help mitigate that tax liability.
There are two potential advantages here:
- The death benefit has the potential to be larger than the total of the RMDs used to pay for the insurance.
- The death benefit payment is usually free of federal taxes, so your heirs shouldn’t get bumped into a higher tax bracket because of their inheritance.
Annuity policies with income-rider guarantees
Some investors purchase annuity contracts to provide a level of safety for future income needs. They may also add riders that provide a guaranteed income level through their life span.
Once this kind of rider is in a contract, most annuity providers don’t allow it to be removed. The result is that the policy holders end up paying extra fees for something they don’t need (at least when market performance is strong).
If you find yourself in this situation, you could consider taking distributions from the annuity and then funding a life insurance policy with the annual proceeds. However, it's important to be aware that you might face current tax ramifications for these withdrawals.
However, it's important to be aware that you might face current tax ramifications for these withdrawals. However, you could take the after-tax distributions to replace an asset that’s tax-inefficient (ordinary income on gains from the annuity) with life insurance, which is a more tax-efficient strategy (tax-free upon death).
Potential benefits include:
- Reduce your taxable estate without giving up your desire to leave a legacy for beneficiaries.
- Increase the benefits for your heirs by using life insurance for a larger, tax-free legacy.
- Decrease a current or future tax burden for yourself, or for your heirs.
Know how each asset will be taxed at death
The table below shows the taxation at death by asset class (based on current federal tax laws):
|investment Category||Income Tax||Estate Tax|
|IRAs/401(k)s (excluding Roth IRAs)||Yes||Yes|
|Immediate Annuit (SPIA)||No||No|
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