A. IRA distributions and the resulting tax implications are something everyone needs to have a holistic view about, as they can affect the amount a beneficiary may inherit upon IRA owner’s death.
- Beginning at age 70½, the IRA owner is required to withdraw an increasing percentage of an IRA’s account value each year until the IRA is exhausted – Required Minimum Distribution (RMD).
- Eventually RMDs will be larger than the expected annual interest growth. When that happens, the IRA may well be at its peak value, typically between ages 85 and 90. When an IRA owner dies, the beneficiary must include taxable amounts received in his or her gross income.
- Because IRAs are frequently transferred at or near their peak value, IRA inheritances are often taxed at higher income tax rates.
It is not uncommon for retirees to die sometime between their 75th and 95th birthday. when that happens IRAs are often passed to the next generation at-or-near peak values.
Because these IRA inheritances are fully taxable to the beneficiaries as ordinary income, they are often taxed at very high rates.
There are two solutions:
1) Solution 1.
Use IRA RMDs to help pay for a life insurance policy equal to income tax due from beneficiary at time of inheritance. Life insurance benefit pays income tax due, full value of the IRA is maintained.
Results: Beneficiary receives life insurance death benefits income tax-free and can use those funds to pay the taxes due on IRA inheritance.
2) Solution 2.
Use IRA RMDs to help pay for a life insurance policy equal to the estimated peak value of the IRA. Loved ones can be named as beneficiary of the life insurance policy and would receive the life insurance death benefits income tax-free under the current tax law.
Results: Total wealth transferred will be more than the amount of net after-tax IRA
inheritance in option ), and the income taxes have been eliminated.
- Beneficiary of life insurance policy receives full death benefit (equal to estimated IRA value) income tax-free.
- Charitable IRA beneficiary receives full value of IRA income tax-free (at IRA owner’s death)
- Zero taxes are paid on either the IRA or the life insurance policy