How to convert a million dollar taxable IRA to ten million dollars of tax-free cash without risk.
* Many individuals have large balances in taxable Individual Retirement Accounts (IRAs) due to long-term growth, rollovers, or both.
* Distributions from such IRAs are taxable as ordinary income before and after the death of the plan participant, because they constitute Income in Respect of a Decedent (IRD). (1)
* "IRA balances at death, including those of Roth IRAs, are includible in the Gross Estate of the plan participant. (2)
* With "at risk" rules," "passive loss rules," long-term and straight-line cost recovery of buildings, etc., life insurance has become one of a select few tax shelters left. In addition, it is an excellent vehicle for saving estate and gift taxes.
THE BASIC TAX PROBLEM
The account balances in all deferred compensation plans, including IRAs, are includible in the participant's gross estate, as well as in the gross income of the successor in interest, but with an itemized deduction for the incremental estate tax paid.
James, a widower, dies with $1 million in his taxable IRA; he is in the maximum 50 percent estate tax bracket. Estate tax payable is $500,000. If distributed to a beneficiary in the 40 percent income tax bracket (federal, state, and local), the same $1 million, assuming the same account balance, is included in the distributee's gross income with $500,000 itemized deduction, resulting in another $200,000 in income tax. Thus, the total tax consumed 70 percent of the IRA funds, leaving the children/grandchildren with $300,000. The situation would be even worse if the phase out of itemized expenses applies or the beneficiary is subject to the Alternative Minimum Tax.
BASIC STRATEGY: THE SOLUTION
Stripped of all but the minimum facts, the solution is almost deceptively simple.
Use the IRA funds to purchase cash value life insurance. That's all! If this can be done properly, the proceeds will be free of both income tax and estate tax! (3)
As shown below, this goal must be accomplished in several steps. Recently, the IRS has cracked down on several strategies involving the abusive use of cash value life insurance. These schemes involve either (1) improper deductions of premiums and/or interest on loans against the policies, or (2) the improper manipulation of cash values. The strategy discussed below does not contain any improper or abusive use of life insurance. No deductions are taken and no lopsided cash value computations are necessary.
Advanced (Step by Step) Strategy
Normally, the following steps will be necessary to convert taxable IRA distributions into life insurance proceeds, tax-free for income and estate (and generation-skipping) tax purposes:
Step 1. Roll Over. An IRA is not allowed to purchase life insurance, with the exception of certain endowment policies, and buying those would not alter the IRA's taxable status. However, other qualified retirement plans may buy life insurance, including profit-sharing plans like Section 401(k) plans, even to the extent of 100 percent of their account balance! Even if the taxpayer is already participating in a qualified plan, it would rarely be possible to have it buy the coveted policy. Thus, what must happen is this:
1. An entity is formed, e.g., a corporation, a Limited Liability Company, a Family Limited Partnership, or merely a sole proprietorship.
2. The entity hires the IRA participant as an employee.
3. The entity establishes a profit-sharing plan, e.g., a Section 401(k) plan.
4. The employee enrolls in the plan.
5. The IRA funds are rolled over into the Section 401 (k) plan, the latter allowing rollover contributions. The rollover is nontaxable. (4)
Step 2. Buy Life Insurance. Once the IRA funds have been received, they may be used to purchase life insurance. The following should be noted:
1. Only cash value insurance may be purchased, since the plan is obligated to make investments, not side bets, on the life expectancy of the insured!
2. The face value of a cash value policy paid up with $1 million is likely to be $10 million or more, depending on the insured's age and health and the type of policy, e.g., universal life, variable and/or adjustable life, or the traditional plain vanilla variety (ordinary/straight/whole life).
3. Only the cash in the plan should be used to pay premiums, since there may be some tax cost involved in getting the policy out of the plan. For the same reason, no contributions should be made to the plan.
4. The account balance should be used to pay a single-premium policy to use up the funds and be ready for a transfer. To avoid the "Modified Endowment Contract" taint (distributions, including policy loans, are taxed as ordinary income to the extent the policy's cash value exceeds premiums paid, or "basis"), the premium cannot be paid faster than the equivalent of seven equal annual payments. (5) This is generally too long to wait for Step 3. The insured must report compensation equal to the term coverage portion of the policy, but only to the extent of the lesser of the rates charged by the insurer for term coverage or the so called "P.S. 58' tables in Rev. Rul. 55-747. (6)
Step 3. Transfer the Policy to the Insured. The policy may be sold to the insured, an insurance trust, or a Family Limited Partnership, to name a few. Often, the best and most efficient alternative is to simply distribute the policy to the insured/participant. This has the advantage of leaving no potential ordinary income in the plan. Also, in the beginning, the cash surrender value/interpolated terminal reserve, is lowest and the gross income is measured thereby.
In fact, everything else being equal, the policy with the lowest possible cash value early on is the most attractive, if there is no need to tap the cash value in the foreseeable future. The initial cash value of a single-premium policy may be minimized with an adjustable, variable life or universal life policy. In fact, given the premium paid, the initial cash value will be lower the higher the face value of the policy, which is probably what the insured wants. The low cash value reduces the taxable distribution, and the higher face value increases the amount available to the insured's family, free of income and wealth transfer taxes!
Gross income resulting from IRA distributions made to a participant age 59 1/2 or younger is generally subject to a 10 percent penalty. (7) By contrast, distributions made from qualified pension and profit-sharing plans due to separation from service are not subject to such penalties, unless the employee is age 55 or younger? (8) Opening this four and one-half year window may alone be worth the rollover, independent of the insurance angle!
Step 4. Borrow Against the Policy. This stop is purely optional. The main reason to take up a policy loan at this point, other than the fact that this is the first and last chance to do so, is to provide the insured with tax-free cash while still alive (for example, to fund his/her retirement). The loan also reduces the taxable gift in the unlikely event there is a need for it. After all, both the loan and the taxable gift would be limited to the cash surrender value. The desire is to minimize the taxable distribution, and thus be covered by the "Applicable Exclusion Amount," currently $1 million until the year 2010! No income can result from a loan, even from a "Modified Endowment Policy," since the cash surrender value would have to exceed the adjusted basis in the policy (the sum of net premiums paid) at the time the loan is made.
Step 5. Transfer the Policy to an Insurance Trust. Once the plan has distributed the life insurance policy to the insured plan participant, it can be transferred again, this time to an Irrevocable Life Insurance Trust (ILIT). The trustee is named beneficiary. By transferring all interests in the policy (the "incidents of ownership") to the trustee and surviving for more than three years, the proceeds completely escape estate and generation-skipping transfer taxes. (9)
Step 6. Monitor the Trust. Once the policy is safely in the trust, numerous refinements are possible, such as:
* The cash value or policy loans may be used to make investments or increase the insurance amount, for example by acquiring large amounts of term insurance or by exercising rights to purchase additional coverage through the present policy.
* Additional transfers may be made to the trust. However, any taxable income in the trust may be taxed to the insured under the grantor trust rules. (10)
* Gifts made to the trust are gifts of future interests, unless one or more beneficiaries has the right to make written demands for funds on the trustee (a "Crummey" provision). Gifts of present interests currently qualify for an annual exclusion of $11,000 per donee, per year. (11)
One reason (other than to reduce taxes) to use an insurance trust is that the trust instrument may empower the trustee to act as a parental substitute with much greater flexibility than permitted by the settlement options in the policy itself. The policy is the contract between the insurer and the owner of the policy, to the exclusion of the insured and the beneficiaries, although two or all three parties may be the same! It is best if the trust instrument is finalized before the transfer, since any retained power by the owner/insured to amend the governing instrument, borrow against the policy, or change beneficiary, etc., must be relinquished more than three years before the policy matures (upon death) to escape estate taxes.
Step 7. Collect the Proceeds and Invest and/or Distribute Them. Once the insured dies, the trustee will collect the insurance proceeds, e.g., the face value, plus accumulated dividends, and less policy loans, including accrued interest. The trustee will follow the instructions in the trust documents, e.g., distribute everything to children and grandchildren, or invest the proceeds in securities and pay the income to the children for life with the remainder going to the grandchildren. The amount involved is likely to be 20 to 50 times the amount in the original IRA on an after-tax basis!
The Ideal Situation
Although anyone with a sizeable IRA balance is a potential candidate for converting it to life insurance, the benefit will be greater the more of the following factors apply:
* The participant is insurable.
* The participant has at least several hundred thousand dollars in a taxable IRA.
* Retirement is at least ten years off, but not too far away (since any distributions should be penalty free), i.e., the candidate should be over age 45 and could be much older.
* The participant does not need the funds, for example because he/she has a generous salary or income from investments.
* The participant has a sizeable estate and is not married.
Even a Roth IRA may be a candidate for a conversion to life insurance if the participant is in the maximum estate tax bracket, but Roth IRAs are relatively new. To the extent there are sizeable Roth IRAs out there, they have likely been converted from a traditional IRA, meaning the income tax has been paid! If this was done very recently, a "recharacterization" may be possible (by October 15 the year after the original conversion).
A second-to-die policy covers two insureds, e.g., husband and wife, but it only pays off once, on the death of the survivor. Since, per definition, the joint life expectancy of a couple is greater than either single life expectancy, the premium is less than that on a single policy. As a result, the face amount can be increased for the same premium, with additional, tax-free dollars passing to the beneficiaries.
Term Insurance: Leveraging the Death Benefit
The policy had to be of the cash value type to satisfy the qualified plan requirements, but the insurance trust is not so restricted! If the sole purpose of the trust is to provide the beneficiaries with tax-free cash, maximum leverage may be used, so as to turn a $10 million face value into $50 million, for example. This can be accomplished by using the cash value or policy loans to buy as much term insurance as possible, perhaps through guaranteed insurability and conversion clauses thoughtfully included in the policy, then augmenting the coverage further by making additional transfers of cash to the trust to pay premiums.
If the IRA participant is not insurable, all is not necessarily lost. To mention just one possibility, the IRA may be transferred tax free to the spouse, if done pursuant to a formal divorce or separation agreement. (12) Later on, they may reconcile and even remarry. After the transfer, a business entity may be formed that at least hires the transferee spouse, sets up a plan for her, performs the rollover, buys the insurance, etc. Exceptionally aggressive unmarried couples may even marry to enable them to separate later!
Nature and Form of Business Entity
It is recommended that the entity chosen to create the plan be either a sole proprietorship or a C corporation. A proprietorship would be the simplest and least expensive way to go. Since the year 2002, self employment plans are formally named "Self-Employment Retirement Plans," previously known as Keogh Plans or H.R. 10 Plans. Partnerships, including Limited Liability Companies, like sole proprietorships, are limited to Self-Employment Retirement Plans, since partners are self employed. S corporations are also limited to non-corporate plans permitted by a partnership. (13)
When choosing a line of business, it should be noted that a corporation may be formed for any legal purpose, e.g., consulting or real estate rental. Although no minimum activity is required, it is important that personal services are, in fact, rendered regularly so the business will not be viewed as a sham.
Well-off participants in taxable IRAs are frequently advised to fund charitable giving with the account, which may be done merely by naming a charity as beneficiary. While this does indeed free the amount in the IRA from income and estate taxes, the participant's family is completely neglected. Even if benefiting charity is the only goal, the amount ultimately going to charity can be multiplied and leveraged with the above conversion-to-life-insurance technique!
Unmarried taxpayers over age 40, including surviving spouses, with large traditional IRAs, should consider converting their IRAs to life insurance trusts, via a rollover to another qualified plan, even if one must be created. This makes it possible, not only to multiply the investment and render it tax free, but to do it on a risk-less basis! If the funds are left in the IRA their value will ultimately result in both ordinary income and inclusion in the gross estate of the participant.
Life insurance permits tax-free buildups in cash value and tax-free distributions of proceeds. Those proceeds may easily be removed from the insured's gross estate, as well. With careful planning and by following the seven steps outlined above, one of the most powerful family tax planning techniques still available may be implemented.
(1) Section 691.
(2) Section 2039.
(3) Sections 101(a)(1) and 2042.
(4) Section 402 (c)(1).
(5) For a definition of Modified Endowment Contract, see Section 7702A. For the income tax consequences of loans and other distributions, see Section 72(e)(2)(B), (4)(A), (5)(C), and (10)(A).
(6) Rev. Rul. 55-747, 1955-2,228.
(7) Section 72(t)(2)(A)(i).
(8) Section 72(t)(2)(A)(v).
(9) Sections 2042 and 2035(a).
(10) Section 677(a)(3).
(11) Section 2503(b).
(12) Section 408(d).
(13) Section 1372.
Rolf Auster, PhD, LLM, CPA, CLU, is a professor in the College of Business Administration at Florida International University in Miami. He can be reached at email@example.com.