Life Insurance Strategies Offer Tax Advantages Over Retirement Funds

By Mary Read CPC, CPF, QPA, and Anthony Competelli
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You’re approaching retirement. Or maybe you’ve already retired. You have succeeded in achieving your goals. What do you do with your qualified retirement plan and IRA savings now?

The Internal Revenue Service (IRS) is waiting for its tax revenue from your money. Money saved in an individual retirement arrangement (IRA), 401(k), 403(b), simplified employee pension (SEP), savings incentive match plan for employees (SIMPLE), cash balance, or defined benefit plan is all qualified retirement money subject to taxation at distribution.

For example, if you have a million-dollar balance in your account but owe $422,500 in income taxes, your account has a net after-tax value of $577,500.

Qualified retirement money has the powerful advantage of being saved pre-tax and growing tax-deferred. However, when the money is distributed, it is 100% taxable as ordinary income. If you don’t need the money and want to postpone distributions and keep the money growing, you will be forced to take required minimum distributions when you reach age 72.

People who have accumulated large amounts of money in qualified retirement accounts typically only take their required minimum distributions, preferring to keep the money growing tax-deferred. They leave the remaining balance to their spouse or children, allowing the money to continue to grow tax-deferred as it is distributed over the beneficiary’s lifetime.

This strategy is commonly referred to as a stretch IRA, but it was eliminated with the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Effective January 1, 2020, the SECURE Act:

  • Defers the required minimum distribution age to 72
  • Allows for IRA contributions past age 72
  • Eliminates the stretch IRA and requires beneficiaries of IRA, Roth IRA, 401(k), or other qualified retirement plans to liquidate the inherited account within 10 years with a few exceptions

Exceptions to the 10-year liquidation requirement include beneficiaries who are disabled or chronically ill, minor children of the deceased retirement account owner, and beneficiaries not more than 10 years younger than the deceased retirement account owner. Spousal beneficiaries can still make the inherited IRA their own and take their required minimum distributions according to their age and the IRS table.

Beneficiaries other than these exceptions will have to liquidate the inherited retirement account by the end of the tenth calendar year following the year of the original retirement account owner’s death. This can be a catastrophic tax event. If the original retirement account owner dies after December 31, 2019, these new rules apply.

Money accumulated in a qualified retirement plan or IRA is taxable income when it is distributed, whether during your life or upon your death. Under the IRS rules, every pre-tax dollar distributed from a qualified retirement plan is taxed as ordinary income.

However, there is one exception. If that dollar is inside a life insurance policy and the life insurance policy is distributed from the qualified retirement plan, only the market value of the policy is taxed as ordinary income. Life insurance is the only asset that is given this unique tax treatment.

Under the IRS rules, a life insurance policy can be purchased and fully paid for within the qualified retirement plan using pre-tax dollars. In the future, the policy can be distributed from the qualified retirement plan. This distribution triggers taxation on the market value of the policy as defined in IRS Revenue Procedure 2005-25.

In this revenue procedure, the IRS provided a safe harbor calculation for defining market value. This calculation is referred to as the PERC calculation. Selecting a policy issued by a financially strong insurance carrier is critical. With use of the proper policy, the strategy reduces the taxes on the qualified retirement account distribution.

Following distribution, the policy is owned personally and treated the same as any individually owned life insurance policy. It will provide a tax-free death benefit to beneficiaries. Loans can be taken from the policy to provide tax-free income. Some policies provide tax-free benefits for use during the insured’s lifetime in the event of terminal, chronic, or critical illness or injury.

In the 401(k) or profit sharing plan, individuals can use the money in their account to insure themselves, their spouse, or their children. The money can be split to insure multiple people such as a husband and wife. This provides flexibility to meet diverse planning needs.

This insurance distribution strategy can:

  • Significantly reduce income taxes on qualified retirement plan distributions
  • Increase tax-free legacies to beneficiaries
  • Eliminate required minimum distributions
  • Reduce or eliminate exposure to market risk
  • Provide tax-free living benefits in case of terminal, chronic, or critical illness or injury
  • Provide tax-free funds not subject to Medicare surcharges and taxation of Social Security income

There is currently $33 trillion sitting in American qualified accounts. This life insurance strategy provides a tax-advantaged alternative to traditional IRAs with their growing taxation and Roth conversions subject to higher taxation. It also provides a solution for those who lost their stretch IRA for legacy planning. This distribution strategy can put control back in account owners’ hands, allowing them to use their money when and how they want.

Ms. Read is national director of pension and protection planning at Pentegra Retirement Services and partner of M&R Business Development Group. A leading authority in qualified retirement plans with more than 30 years’ experience, she has an extensive background in plan design and development and experience as a marketing executive, financial professional, pension analyst, and pension compliance manager. She is a frequent speaker on qualified plans and contributor to industry publications. And, she is the author of three books.

Mr. Competelli is president and CEO of National Retirement Group and a former BENCOR regional manager. He is a graduate of the State University System of New York at Farmingdale with a degree in finance. He started his own corporation, Financial Reserve Services, in 1990, which he sold to USRP in December 2009. He began working with BENCOR in 2005. He also is a certified tax preparer through AARP, volunteering with local chapters of the Lighthouse of the Blind in preparing tax returns. For more information, contact financialfocus100@gmail.com.

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