Create a Larger Legacy Using Required Minimum Distributions

Grandfather and grandson playing chess on the grass in the meadow

Are you facing the situation where you have to start taking required minimum distributions from your qualified accounts but you don’t need the income for retirement?  If this is the case, congratulations to you.  You planned and saved well.  And now you are faced with a financially comfortable retirement.  But as age 70 ½ comes closer, you know the Internal Revenue Service is going to require you to start taking distributions from your qualified accounts, whether you need the income or not.  What to do?

One option to consider is paying life insurance premiums with those distributions.  In doing so, you would be taking a taxable asset and creating a tax-free legacy to your beneficiaries.1  Intrigued?  Let me explain.  You have to take your minimum distributions.  But if you take only your required minimum each year, there is the possibility that you will be leaving a very large qualified asset to your named beneficiaries.  Upon your death, your beneficiaries will be required to either take the balance in the account in a lump sum or start taking minimum distributions over their single life expectancy.  Whichever option is chosen, the distribution taken will be taxable at the beneficiary’s personal income tax bracket.

But if you take distributions from your qualified asset while living, you can pay your tax on the distribution and use the net amount to pay the premiums on a life insurance policy.  The life insurance death benefit will be passed income tax free to your beneficiaries.  Spending down a taxable asset by buying life insurance leaves less qualified money for your beneficiaries to deal with in the future.

Let’s look at an example where the owner takes only the minimum distribution each year.

John, age 70 has $1 million of qualified money in an IRA.  His children Joe, age 37, and Julie, age 40, are the primary beneficiaries.

If we assume John takes minimum distributions until his death at age 85 and used an assumed interest rate of 5%, John would take distributions totaling $832,350 over 15 years.  If he was in a personal 33% income tax bracket, he will pay $274,675 in taxes.  Upon his death, the account balance would be $1,005,404 which would be split evenly between his two children.

If Joe and Julie elect to split the account into two separate accounts, they would each have $502,702 upon John’s death.  If they elect to take their amount as a lump sum, and are each in a 33% personal income tax bracket, that would mean they would each pay a total of $165,892 in taxes, netting each of them $336,810.

What if John took a fixed amount each year from the IRA and used that money to purchase life insurance?

Let’s assume he purchases a universal life policy with a $1 million death benefit and an assumed premium of $60,000 based on a 70 year old with a standard, non-smoker rating.  John could gross up the required minimum distribution to $89,552 to net the $60,000 premium annually after taxes.  If John were to die at age 85, assuming a 5% growth in the account, he would have taken a total of $1,432,832 from his qualified account and paid taxes of $472,835.  Upon his death, the remaining account balance of $64,299 would be split evenly between his two children.

Now Joe and Julie would split a remaining balance of $64,299, or $32,149 per beneficiary.  In electing to take the lump sum, they would each pay a tax of $10,609, leaving them each with $21,540 after taxes.  But in addition, each child will receive half of the life insurance proceeds, or $500,000 each, income tax free.

It is possible that beneficiaries could receive higher payouts if they were to stretch the qualified monies over their single life expectancy.  But they will have to pay tax on each annual distribution.  Shifting that money from qualified to non-qualified can create a tax free legacy to your beneficiaries.

Be aware that the death benefit will be included in the calculation of your estate taxes unless it is placed in an irrevocable trust that takes it out of the estate. Current estate limits are quite generous, but if the life insurance death benefit will put your estate near $5 million (for a single filer), you should consider the effects on your estate with your tax and legal advisors.

1. Internal Revenue Code § 101(a)(1). There are some exceptions to this rule. Please consult a qualified tax professional for advice concerning your individual situation.