By Parag P. Patel, Esq.
Few people realize that, even though they may have a modest estate, their families may owe the government hundreds of thousands of dollars because they own a life insurance policy with a substantial death benefit. This is because life insurance proceeds, while not subject to federal income tax, are considered part of your taxable estate and are subject to federal estate tax at rates from 37% to 55%.
The solution to this problem is to create an irrevocable life insurance trust to own the policy and receive the policy proceeds on your death. A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as well as in the estate of your surviving spouse. It also protects the trust beneficiaries from their own "excesses," against their creditors and in the event of divorce. Moreover, the trust also provides reliable management for the trust assets. Here's how the irrevocable life insurance trust works.
You create an irrevocable life insurance trust to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. The contributions you make to the trust for premium payments generally will qualify for the annual gift tax exclusion. The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee's discretion, may be paid or applied to or for the benefit of your spouse and descendants. This allows indirect access to the cash surrender value of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable. On your death, the trust continues for the benefit of your spouse during his or her lifetime. Your spouse is given certain beneficial interests in the trust, such as entitlement to income, limited invasion rights, and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.
If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you.
My experience indicates that for most clients this is an issue. If you have an estate plan, review your documents to ensure proper estate tax planning is in place. If you have no estate plan, you should talk to an estate planning attorney to minimize your estate tax bill and maximize your estate assets for your family.
Saturday, December 27, 2008
Wednesday, December 10, 2008
How to Stretch Your IRA Into a Family Fortune
Your individual retirement account (IRA) can do much more than provide funds for your retirement -- it can be stretched to provide millions of dollars in payouts to your children, grandchildren or others you choose to be beneficiaries.
Example: An IRA balance of only $100,000 may provide more than $8 million in future distributions when left to a young child.
What you need to know...
stretching an IRA
Most IRA owners think of their IRAs as providing savings only for themselves -- and their spouses, if married.
This is largely because traditional IRAs are subject to annual required minimum distributions (RMDs) that begin at age 70½ and cause the IRA's funds to be distributed over the life expectancy of its owner.
IRA owners typically believe that if they live to their full life expectancies (or longer), there will be little or nothing left in their IRAs to leave to heirs.
Surprise: The life expectancies that govern mandatory IRA distributions as given in IRS tables are not actual life expectancies. The IRS life expectancies are much longer than actual average life expectancies.
The table below shows the life expectancies as provided by the IRS's "Uniform Lifetime Table" for IRA distributions, which is used by most IRA owners (single persons and married persons with spouses not more than 10 years younger) to determine the size of RMDs, versus actual average life expectancies as given by the National Center for Health Statistics.
Life Expectancies
Age | IRA Table Years | Actual Years |
70 | 27.4 | 14.9 |
75 | 22.9 | 11.8 |
80 | 18.7 | 9.0 |
85 | 14.8 | 6.8 |
90 | 11.4 | 5.0 |
95 | 8.6 | 3.6 |
100 | 6.3 | 2.6 |
Key: As a result of the difference, you may be able to leave funds in an IRA for much longer than you expect.
Moreover, initial RMDs may be so small that your IRA will continue to grow in value for years after distributions begin.
Explanation: At age 70½, when RMDs start, life expectancy under the IRS table is 27.4 years.
Each year's RMD is determined by dividing the IRA balance by the number of years in life expectancy -- so at age 70½, the RMD is 1/27.4, or 3.6%, of the IRA's value. If your IRA earns more than this, it will continue to grow in value in spite of the distributions.
So, if you take only minimum distributions each year from your IRA and it earns 8% annually, it will continue to grow until you reach age 88! (Under the IRS table, the RMD won't reach 8% of the IRA's value until then.)
the stretch
Once a beneficiary receives an IRA, its value may resume growing at a much faster rate.
Rule: A beneficiary can take required distributions over his/her life expectancy starting in the year after the inheritance. But if the beneficiary is young, life expectancy may be 50, 60 or 70 years, or even more, making initial RMDs so small that the IRA can grow rapidly.
Example: A grandparent leaves a $100,000 balance in an IRA that earns 8% annually to a one-year-old grandchild. The child's life expectancy under the IRS single life tables used by beneficiaries is 81.6 years, so the initial RMD is only 1.2% of the IRA balance.
Under the applicable IRS life expectancy table, the RMD won't reach 8% of the IRA balance until the grandchild is 70 years old. If the child takes minimum distributions, the IRA balance will grow for 69 years -- even with the child taking minimum distributions from it all that time.
In total, over the 82 years of the child's life expectancy, the IRA will pay the child $8,167,629 dollars -- more than eight million dollars from the initial $100,000.
how to do it
Steps to make the most of your IRAs...
Roll over funds from other retirement accounts into IRAs. This will let you use the "stretch IRA" strategy for as much of your retirement savings as possible.
Open Roth IRAs or convert traditional IRAs to Roths if eligible. These are even better to stretch than traditional IRAs. Distributions from them are tax free and there are no required minimum distributions for the original IRA owner. (Beneficiaries must take RMDs.) This lets you save funds in them for longer periods to earn more compounding.
Plan retirement spending to preserve IRAs. Build your investment portfolio for your retirement years. Best: Plan to consume IRA funds last. This will provide more tax-favored compounding within the IRA for you, and help you leave a bigger IRA balance to heirs.
Rules for the stretch
The beneficiary who takes a stretch IRA must be a named person, not your estate.
Be sure the custodial agreement with your IRA trustee provides for allowing a stretch IRA -- not all do.
Either have separate IRAs for each beneficiary or formally "split" your IRA among them, such as by designating a set percentage as going to each. Traps...
If an IRA with multiple beneficiaries isn't split up, the life expectancy of the oldest governs distributions for the others.
If a non-person (such as a charity) is co-beneficiary of an IRA, its life span of zero applies to all other co-beneficiaries, forcing them to take rapid distributions -- and eliminating the stretch.
When an IRA is left to a spouse, to use its funds to set up a stretch IRA for a child (or other beneficiary), the spouse must first convert the inherited IRA into his own IRA (only a spouse can do this), and then name the child (or other party) as beneficiary.
After the spouse dies, the inherited IRA must be retitled with the deceased owner's name in it, or the IRS will deem it distributed and taxable.
Example: "Frederic Jackson, IRA (deceased June 15, 2006) for the benefit of Sandra Jackson, beneficiary."
Important: Convince your beneficiaries of the importance of taking minimum "stretch" distributions. If they empty your IRA of cash as soon as they inherit it, all the potential decades of future compounding will be lost.
Saver: A trust can be named as beneficiary of your IRA to pass through payments to an heir, assuring that only minimum RMDs are taken (unless the trustee deems there is good reason to take larger distributions) so compounding is maximized.
Many technical rules apply to trusts and IRAs generally, so consult an IRA expert.
Friday, December 5, 2008
Stretch your IRA
How would you like to make your grandchildren millionaires? Would it put a smile on your face to insure that your great-grandchildren never have to think about money?
Its easy ... if you have the discipline and self control to budget annual savings, if you're right about any number of assumptions and if you read on.
We're talking about Stretch IRAs.
Individual Retirement Accounts (IRAs) have been one of the most popular retirement vehicles for the past generation of investors. They let you enjoy tax-deferred savings over an extended period of time.
A Stretch IRA is a term commonly used to describe an IRA established to extend the period of tax-deferred earnings, typically over multiple generations.
In the short run, you can use the concept to reduce the required withdrawal you must take from the account if you're retired or at least age 70 1/2, and you'll cut your current income tax bill as well.
Meanwhile, because you are extending the IRA payout until your grandchildren retire (or further, if appropriate), you get substantial additional deferral years to compound the earnings growth. Depending on the earnings and payout rates, potential payouts may approach multi-million-dollar levels.
Distribution rules simplified
All of this becomes possible thanks to rules a few years ago that simplified distribution rules for qualified plans and IRAs. These rules:
Provide a uniform table to determine lifetime required minimum distributions regardless of age.
Permit a beneficiary to be determined up to the end of the year following the death of the primary owner.
Allow the normal life expectancy that would apply at the time of death to be taken into account in the calculation of post-death minimum distributions.
The rules let you determine your minimum distribution each year, based on your current age and account balance. The new distribution schedule is based on the joint life expectancies of you and a survivor who's at least 10 years younger. It assumes that both begin receiving distributions beginning at age 70. (There's an even simpler distribution table for spouses who are not more than 10 years apart in age.)
These new rules also allow you to determine your beneficiary up to your death, and to select a beneficiary more than 10 years younger than you. These moves are what combine to reduce current minimum distribution requirements and extend the deferral period. (Remember, you can always take more than the minimum required annual distribution from your retirement plan. These changes affect people who want to take out the lowest required amount.)
Checking out the numbers
Lets take an example. Assume I started my IRA at age 29. (I know, I know: I should have started earlier.) And I plan to contribute $2,000 per year until age 69 when I die. That gives me 40 years of compounding, and, at a 7% rate of return, my IRA at the end of that time should be worth $399,270.
I leave the IRA to my wife, whos 20 years younger than I am and who lives until shes 69. Thats another 20 years of tax-deferred compounding, which, at 7%, compounded monthly, brings the value of the account to $1,612,547.
She leaves the account to our granddaughter, who has additional 70 years of compounding. At the same 7% rate, her account is then worth $213,487,584 when she retires!
I can see the smile on her face now ... even if the money becomes all taxable. I can hear her children laughing, freed from any financial concerns.
(The numbers potentially could be bigger. Thanks to the 2001 and 2003 tax cut laws, you have been able to make larger contributions to IRAs. For 2005 and 2006, the contribution limit is $4,000 a year. It will rise to $5,000 a year starting in 2008.)
IRAs have been an excellent and extremely popular investment tool. As of 2004, millions of Americans have saved $3.07 trillion for retirement using IRAs and employer-sponsored defined contribution plans, according to the Investment Company Institute. The IRA total was $1.49 trillion.
Is the Stretch IRA right for you?
But before you jump at Stretch IRAs, recognize that its all in the assumptions. Any changes in the assumptions change the potential value of your investment fund. A Stretch IRA assumes:
You dont need the money, either before or after retirement. That's a big assumption.
You will take the smallest amount of money the law allows, and at the latest time it allows, without penalty (currently at age 70 1/2).
Your primary beneficiaries die early, before they can deplete the investment fund.
That tax laws will remain constant and not change.
That inflation is minimal, and will not significantly cut into your rate of return and the ending values of the account.
That your returns dont vary. Most Stretch IRAs assume a constant rate of return that can be projected accurately over the long term. In the real world, those investors in the stock market who got in six years ago and got out two years ago -- before the market crash -- will have a very different rate of return than those who started their investment portfolio two years ago.
Stretch IRAs are a great way to accumulate financial freedom for your heirs. But their true value depends on realistic assumptions being made and realized. Lots of things can happen that will stunt the growth of an IRA. And you have to be sure the account fits YOUR needs.
But that $213 million looks awfully attractive to me!
Its easy ... if you have the discipline and self control to budget annual savings, if you're right about any number of assumptions and if you read on.
We're talking about Stretch IRAs.
Individual Retirement Accounts (IRAs) have been one of the most popular retirement vehicles for the past generation of investors. They let you enjoy tax-deferred savings over an extended period of time.
A Stretch IRA is a term commonly used to describe an IRA established to extend the period of tax-deferred earnings, typically over multiple generations.
In the short run, you can use the concept to reduce the required withdrawal you must take from the account if you're retired or at least age 70 1/2, and you'll cut your current income tax bill as well.
Meanwhile, because you are extending the IRA payout until your grandchildren retire (or further, if appropriate), you get substantial additional deferral years to compound the earnings growth. Depending on the earnings and payout rates, potential payouts may approach multi-million-dollar levels.
Distribution rules simplified
All of this becomes possible thanks to rules a few years ago that simplified distribution rules for qualified plans and IRAs. These rules:
Provide a uniform table to determine lifetime required minimum distributions regardless of age.
Permit a beneficiary to be determined up to the end of the year following the death of the primary owner.
Allow the normal life expectancy that would apply at the time of death to be taken into account in the calculation of post-death minimum distributions.
The rules let you determine your minimum distribution each year, based on your current age and account balance. The new distribution schedule is based on the joint life expectancies of you and a survivor who's at least 10 years younger. It assumes that both begin receiving distributions beginning at age 70. (There's an even simpler distribution table for spouses who are not more than 10 years apart in age.)
These new rules also allow you to determine your beneficiary up to your death, and to select a beneficiary more than 10 years younger than you. These moves are what combine to reduce current minimum distribution requirements and extend the deferral period. (Remember, you can always take more than the minimum required annual distribution from your retirement plan. These changes affect people who want to take out the lowest required amount.)
Checking out the numbers
Lets take an example. Assume I started my IRA at age 29. (I know, I know: I should have started earlier.) And I plan to contribute $2,000 per year until age 69 when I die. That gives me 40 years of compounding, and, at a 7% rate of return, my IRA at the end of that time should be worth $399,270.
I leave the IRA to my wife, whos 20 years younger than I am and who lives until shes 69. Thats another 20 years of tax-deferred compounding, which, at 7%, compounded monthly, brings the value of the account to $1,612,547.
She leaves the account to our granddaughter, who has additional 70 years of compounding. At the same 7% rate, her account is then worth $213,487,584 when she retires!
I can see the smile on her face now ... even if the money becomes all taxable. I can hear her children laughing, freed from any financial concerns.
(The numbers potentially could be bigger. Thanks to the 2001 and 2003 tax cut laws, you have been able to make larger contributions to IRAs. For 2005 and 2006, the contribution limit is $4,000 a year. It will rise to $5,000 a year starting in 2008.)
IRAs have been an excellent and extremely popular investment tool. As of 2004, millions of Americans have saved $3.07 trillion for retirement using IRAs and employer-sponsored defined contribution plans, according to the Investment Company Institute. The IRA total was $1.49 trillion.
Is the Stretch IRA right for you?
But before you jump at Stretch IRAs, recognize that its all in the assumptions. Any changes in the assumptions change the potential value of your investment fund. A Stretch IRA assumes:
You dont need the money, either before or after retirement. That's a big assumption.
You will take the smallest amount of money the law allows, and at the latest time it allows, without penalty (currently at age 70 1/2).
Your primary beneficiaries die early, before they can deplete the investment fund.
That tax laws will remain constant and not change.
That inflation is minimal, and will not significantly cut into your rate of return and the ending values of the account.
That your returns dont vary. Most Stretch IRAs assume a constant rate of return that can be projected accurately over the long term. In the real world, those investors in the stock market who got in six years ago and got out two years ago -- before the market crash -- will have a very different rate of return than those who started their investment portfolio two years ago.
Stretch IRAs are a great way to accumulate financial freedom for your heirs. But their true value depends on realistic assumptions being made and realized. Lots of things can happen that will stunt the growth of an IRA. And you have to be sure the account fits YOUR needs.
But that $213 million looks awfully attractive to me!
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