The Individual Retirement Account (“IRA”) has been proven to be a wonderful vehicle to reduce current income tax and shelter the gains on the capital appreciation of the investments within the IRA. However, without proper planning, at the death of the owner, the capital appreciation can be all but wiped out by estate and income tax. The combined taxes can wipe out as much as 70% of the value of the IRA.
Consider the following example: Dr. Smith has a net worth of $5,000,000, of which $1,000,000 is in his IRA. Upon Dr. Smith’s death, the estate tax (48%) on the IRA would be approximately $480,000, and the income tax (36%) on the appreciation in the IRA would be approximately $360,000, which would be reduced to approximately $180,000 after the deduction for the estate tax is paid. Thus, the combined taxes are approximately $660,000, or 66% of the original $1,000,000 in the IRA, leaving only $340,000 to be distributed to Dr. Smith’s heirs.
The conventional advice to solve the 70% tax problem is to make charitable contributions with the assets in the IRA, whether through a charitable remainder trust or a charitable foundation. While this strategy avoids the combined estate and income tax, the funds are no longer available for the decedent’s heirs.
Another possible solution is to create a “stretch” IRA so that the income tax is diminished because the required payout from the IRA is lower, leaving assets in the IRA to appreciate over time. If the “stretch” IRA is left to heirs who will not have estate tax problems themselves, this is a good solution; however, if the heirs will themselves have taxable estates, the 70% problem is only delayed.
There is a more favorable solution. In our example, Dr. Smith would create a profit sharing account and roll the IRA assets over into the new account. The profit sharing account then uses the assets to purchase a life insurance policy – an IRA cannot own life insurance, but a profit sharing plan can. By using all or a large part of the profit sharing account balance to purchase the life insurance policy, Dr. Smith could purchase a significant amount of life insurance, say $5,000,000. Then, at 59½, the life insurance policy is distributed tax-free, assuming it has no value (generally determined by reference to its then cash value), to Dr. Smith, who then gifts it to an irrevocable life insurance trust (“ILIT”). In the alternative, the ILIT purchases the life insurance policy from the IRA with funds in the ILIT that Dr. Smith has gifted to the ILIT over time, taking advantage of the annual exclusion to make tax-free gifts to the ILIT.
The result: upon Dr. Smith’s death, the life insurance proceeds are not included in Dr. Smith’s taxable estate, and the distributions are not subject to income tax except to the extent that the distributions include income earned after Dr. Smith’s death. This strategy would avoid much of the income tax on the IRA and all of the estate tax.
Please do not hesitate to telephone us if you would have significant assets in your IRA and would like to explore the foregoing strategy to minimize the impact of combined estate and gift taxes on your IRA.