Retirement Maximization-Using Funds In Your IRA To Purchase Life Insurance

By: Randall A. Denha, J.D., LL.M.

An Individual Retirement Account, or IRA, is basically a savings account with tax breaks which allows a participant the ability to grow such savings on a tax deferred basis for eventual retirement.  They are easy to set up, typically by a financial institution. However, the Toweverdhe money you’ve accumulated in retirement savings plans won’t be tax-deferred forever.

A large balance IRA or other tax-deferred retirement account is actually a looming debt to the IRS. As that IRA grows so does that debt, just like an unpaid credit card, compounding as the account value increases. Let me explain further. While the tax debt is deferred, the deferral is limited due to required minimum distributions (RMDs) that force the taxes out with withdrawals beginning after age 70-½. As we know, the eventual tax rate on future IRA withdrawals is unknown, but it’s likely that taxes may go up in future years.

Unlike other non-IRA type investments, funds in IRAs and 401(k)s at death remain taxable. There is no step-up in basis, as there would be for a highly appreciated stock held outside of an IRA, eliminating the income tax at death. IRA and 401(k) beneficiaries are subject to income tax on post-death RMDs as well as possible estate taxes as well!

Of course, all of the foregoing assumes a ramp up in values because of sound investing and stock market performance. Traditionally, the stock market increases over time, but if the market declines when retirement funds are needed, less of the remaining funds are available for future growth.

For all of these issues, large IRAs are in fact a poor retirement vehicle. There are too many risks and uncertainties. That is not a good foundation for a long-term retirement plan. When asked, most clients approaching or in retirement want more certainty. They also want guarantees, growth, control, safety, protection, access, liquidity and low or no taxes. But most of all, they want to sleep at night.

Is there a way to use the built-up value inside of an IRA (which will be taxed) and buy a more predictable asset with less risk and not subject to any tax?  Yes.  Life Insurance. Many people, once they reach 70-1/2, are forced to withdraw more money from their IRA than they wish to. These individuals should consider using the after-tax proceeds from the required minimum distributions (RMDs) to pay for life insurance premiums. After the death of the IRA owner, the life insurance proceeds can be used to pay any estate tax or other post-death expenses so the beneficiaries of the IRA will not have to.

The long-term master plan is for the family to end up building wealth in a permanent life insurance policy, rather than building a tax debt in an IRA. If you are in retirement and are required to make withdrawals from your assets to meet normal living expenses, using the cash value from your insurance policies is more cost-effective than withdrawing funds from taxable retirement funds. Withdrawals from cash value will have no impact on your tax bracket. It is possible that withdrawals from your taxable retirement accounts will push you into a higher tax bracket.

The advantages to this technique are the following:

• The newly purchased insurance policy is available to double as a lifetime retirement account if needed, except that there are no RMDs and no income taxes.
• There is also no stock market risk due to guarantees that can be set up in the policy. There is liquidity and access for lifetime needs.
• Then, of course, there is the death benefit, which presents an income tax-free windfall for beneficiaries. Life insurance is also a better asset to leave to a trust for beneficiaries if there are control, protection or management issues with beneficiaries.

The disadvantages to this technique are the following:

• Income taxes are paid up front, but much of this money will be going to the IRS anyway over time.
• Funds are tied up long term
• Any policy withdrawals reduce death benefit
• There is no tax deduction for contributing to a life insurance policy, but as you can see from the above IRA tax problems, a deduction for an IRA contribution becomes a growing tax debt waiting to be paid.
• With life insurance, clients won’t benefit from the upside of the stock market, but they also won’t lose money, plus they can use other funds for market exposure if they wish. If those investments do produce gains, the appreciation can escape income tax at death with the step-up in basis.

Perhaps the biggest downside is that life insurance is a long-term planning solution that requires payments in the short term for larger benefits long-term. Clients have to focus on the long-term solution under both scenarios: having funds in IRAs or life insurance. At retirement and after death, life insurance wins big and the benefit widens substantially over time, without having to hope the stock market will carry the day.

All this adds up to retirement security and peace of mind, something that large IRAs cannot provide with certainty. Large IRAs need to be transitioned to tax-free territory using the tax benefits of life insurance. Permanent life insurance is a much better long-term retirement asset in this regard with this particular strategy.