Tuesday, February 21, 2006
Converting Retirement Plans to Life Insurance
Assume that an older, fairly wealthy widow(er) has a substantial amount in tax-deferred retirement plans such as defined contribution pension plans, 401k plans, 403b plans, and traditional IRAs. The widow(er) wants to leave the retirement plans to his or her children.
The problem is that when the children inherit the retirement plans and take distributions from them, the distributions are fully taxable to the children. The retirement plans are income in respect of a decedent (known as IRD), which is taxable. In addition, the balances in the retirement plans are fully included in the decedent's gross estate for estate tax purposes.
Is there any way to achieve the parent's goal of having enough money to pay living expenses and yet leave a good inheritance to the children? The answer is yes if the older, fairly wealthy parent is insurable for life insurance purposes.
Here is how the solution would work. The parent obtains a life insurance policy large enough to replace the balances in all the tax-deferred retirement plans. However, the parent is not the owner of the life insurance. The parent forms an irrevocable life insurance trust that has a "Crummey Powers" clause, and the irrevocable life insurance trust owns the life insurance policy. This technique will keep the value of the life insurance out of the decedent's gross estate.
A "Crummey Powers" clause gets its name from a court case. It has to do with whether a gift is subject to gift tax. Gifts that are less than the annual exclusion amount are exempt from gift tax as long as the gift is a present interest in property. A "Crummey Powers" clause allows the beneficiary of a life insurance trust the right to withdraw gifts made to the trust that the donor intends to pay for life insurance premiums. As long as the beneficiary has the right to withdraw the donation under the "Crummey Powers" clause, it is a gift of a present interest in property.
Assume that the beneficiary does not exercise the right to withdraw the donation. The irrevocable life insurance trust will use the donation by the parent to pay the premiums on the life insurance.
Where does the parent obtain the money to donate the money to the trust to pay the life insurance premiums? The parent converts the balances in the retirement plans into a life annuity. Therefore, the parent receives payments for life and uses part of them to pay the insurance premiums through the trust. At the parent's death, the annuity is worth zero. Therefore, the children do not have any income in respect of a decedent. Nothing from the annuity is included in the gross estate.
The life insurance company pays the children the proceeds of the life insurance policy. The proceeds are not subject to income tax. They are not subject to estate tax because the decedent did not own the policy.
This plan allows the parent to have an income stream during life from the annuity. The annuity payments would be fully taxable unless the individual has any basis in the annuity. The children receive money from the life insurance policy and do not have to pay any income tax or estate tax on it.
This plan converts amounts that would be subject to income tax and estate tax to amounts that are not subject to income tax or estate tax in the hands of the children. The parent can donate money to charity or engage in additional income tax planning to minimize the income tax on the annuity payments during life.
This strategy requires the services of a tax advisor, attorney, and a life insurance agent. They all must be competent and exercise great care in implementing the strategy. However, if done correctly, this strategy can result in substantial tax savings. It also gives the parent more peace of mind knowing that the children will not have to pay taxes on the life insurance.
The problem is that when the children inherit the retirement plans and take distributions from them, the distributions are fully taxable to the children. The retirement plans are income in respect of a decedent (known as IRD), which is taxable. In addition, the balances in the retirement plans are fully included in the decedent's gross estate for estate tax purposes.
Is there any way to achieve the parent's goal of having enough money to pay living expenses and yet leave a good inheritance to the children? The answer is yes if the older, fairly wealthy parent is insurable for life insurance purposes.
Here is how the solution would work. The parent obtains a life insurance policy large enough to replace the balances in all the tax-deferred retirement plans. However, the parent is not the owner of the life insurance. The parent forms an irrevocable life insurance trust that has a "Crummey Powers" clause, and the irrevocable life insurance trust owns the life insurance policy. This technique will keep the value of the life insurance out of the decedent's gross estate.
A "Crummey Powers" clause gets its name from a court case. It has to do with whether a gift is subject to gift tax. Gifts that are less than the annual exclusion amount are exempt from gift tax as long as the gift is a present interest in property. A "Crummey Powers" clause allows the beneficiary of a life insurance trust the right to withdraw gifts made to the trust that the donor intends to pay for life insurance premiums. As long as the beneficiary has the right to withdraw the donation under the "Crummey Powers" clause, it is a gift of a present interest in property.
Assume that the beneficiary does not exercise the right to withdraw the donation. The irrevocable life insurance trust will use the donation by the parent to pay the premiums on the life insurance.
Where does the parent obtain the money to donate the money to the trust to pay the life insurance premiums? The parent converts the balances in the retirement plans into a life annuity. Therefore, the parent receives payments for life and uses part of them to pay the insurance premiums through the trust. At the parent's death, the annuity is worth zero. Therefore, the children do not have any income in respect of a decedent. Nothing from the annuity is included in the gross estate.
The life insurance company pays the children the proceeds of the life insurance policy. The proceeds are not subject to income tax. They are not subject to estate tax because the decedent did not own the policy.
This plan allows the parent to have an income stream during life from the annuity. The annuity payments would be fully taxable unless the individual has any basis in the annuity. The children receive money from the life insurance policy and do not have to pay any income tax or estate tax on it.
This plan converts amounts that would be subject to income tax and estate tax to amounts that are not subject to income tax or estate tax in the hands of the children. The parent can donate money to charity or engage in additional income tax planning to minimize the income tax on the annuity payments during life.
This strategy requires the services of a tax advisor, attorney, and a life insurance agent. They all must be competent and exercise great care in implementing the strategy. However, if done correctly, this strategy can result in substantial tax savings. It also gives the parent more peace of mind knowing that the children will not have to pay taxes on the life insurance.
