Solutions for LTC and Inheritance Planning Using RMDs and Life Insurance

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1 Solutions for LTC and Inheritance Planning Using RMDs and Life Insurance Shawn Britt, CLU, CLTC Director, Advanced Consulting Group Nationwide The end of each year brings many clients to start thinking about upcoming tax preparation, and for some, to call their financial professional regarding required minimum distributions from their IRA. They often ask, Do I really have to take a distribution from my IRA this year? I really don t need it! While the answer is still Yes, there are some creative uses for the Required Minimum Distribution (RMD) that can enhance the client s financial picture. This article will address two solutions using RMDs to fund life insurance for maximizing asset enhancement and protection. Providing a legacy to grandchildren with remaining IRA assets without disinheriting their adult child Protecting current assets from the threat of long-term care expenses with a win/win solution When using RMDs to fund both of the following life insurance concepts, it may be beneficial to plan a level RMD amount that meets the annual RMD requirement. This figure can be determined by an RMD calculator or other financial software illustrating RMD concepts. With this level figure, planning a level annual life insurance premium is simplified. Legacy Replacement and Enhancement Providing a legacy to grandchildren without disinheriting the adult child Commonly, a client might take RMDs throughout their retirement and absorb it into other savings or just spend it. Upon their death (and death of spouse), there is an IRA balance that is ultimately inherited by the adult children. While the adult child beneficiary has the option to stretch the inheritance, they often choose not too. Rather, they take the lump sum, pay tax and go on with their own life which may already be in or close to retirement. However, a client s unneeded IRA distribution (RMD) could be more efficiently used to provide an inheritance to the adult children as well as grandchildren. The RMD funds are 1

2 used as a premium for life insurance, creating a replacement for the IRA account in the form of a tax free death benefit that would be left to the adult child (estate tax free as well with proper planning). This would then allow for the remaining IRA asset to be left to the grandchildren. If the remaining IRA is set up as a Stretch IRA, a significant inheritance for grandchildren would result. Keep in mind some scenarios could result in generation skipping tax, so please consult your legal and/or tax advisor. Let s take a look at a hypothetical case example: Marilyn has a $400,000 balance in her IRA. She soon has to begin taking her RMD, and would like to find a way to better utilize this money. She has more than adequate assets and retirement benefits to live on and really doesn t foresee ever needing income from her IRA. Marilyn has a successful son John, and though Marilyn intends to leave her remaining estate to John, she would also like to provide a meaningful inheritance to her grand-daughter Lorraine. She has considered leaving the balance of her IRA to Lorraine. However, she worries whether John will understand not receiving the IRA proceeds in his inheritance. Marilyn s financial professional proposed the following plan that would allow Marilyn to fulfill both her goals. Marilyn, insurance age 71, is still in good health with a non-tobacco standard rate class. Marilyn will take the level amount of $20,000 per year from her IRA, which will meet her RMD obligation. $16,000 per year will be allocated towards a life insurance premium. The remaining funds will be used to help pay income tax on the distribution. She will then purchase a Nationwide YourLife No-lapse Guarantee Universal Life insurance policy which will provide a death benefit of $513,000 and replace the IRA account she would have left to her son John. Upon Marilyn s death, assumed to be age 85, the account balance of the IRA will still be $417,423 assuming an annual rate of return of 6%. But, instead of leaving a taxable IRA account to John, Marilyn is going to leave him a tax free legacy of $513,000 through the life insurance death benefit. If John were in a 30% tax bracket and inherited the IRA balance, he would only have $292,196 left after taxes were paid. However, because life insurance proceeds are inherited by the beneficiary income tax free (estate tax free as well with proper planning); Marilyn will be able to provide her son with a full tax free legacy of $513,000. Marilyn can then leave the $417,423 balance of the IRA to her grand-daughter Lorraine. If the IRA is set up in advance by Marilyn to be a Stretch IRA payout, Lorraine over her lifetime will receive a total of $2,033,325. (Keep in mind the funds paid to Lorraine would be subject to taxation when coming from a traditional IRA.) 2

3 Marilyn is pleased that she can provide a more valuable inheritance to John at the same time provide a lifetime income to Lorraine that will add up to a substantial inheritance. This strategy is appropriate as long as the death benefit can replace the IRA with a sum at least equal to the after tax amount of the IRA the adult child would have inherited as a lump sum since life insurance proceeds are tax free to the beneficiary. IRA Account value at Marylyn s age 70 1/2 $400,000 IRA Account value at Marylyn s death $417,423 RMD fulfilled with $20,000 annual distribution $417,423 balance left to Lorraine $16,000 used to purchase life insurance. Remaining funds used to pay taxes. Marilyn sets up Lorraine s inheritance as a Stretch IRA Death benefit to John $513,000 (tax free) Lorraine s total income over her life expectancy is $2,033,325 *Marilyn is 70 ½ with an insurance age of 71 and Lorraine is 20 years old when this strategy is initiated. The No-Lapse Guarantee Universal Life policy is set up with annual premiums of $16,000 per year, paid on an annual basis and guarantees the contract for life as long as premium obligations are met (and based on the claims paying ability of the company). 3

4 Using Survivorship Life Insurance If you were to assume that Marilyn s husband were still alive and age 72, was rated standard non-tobacco when this strategy was implemented, and that the IRA and RMDs were the same as in the example above, it would result in a tax free death benefit to John of $575,860. Protecting current assets from the threat of long-term care expenses The biggest threat to a secure retirement and/or to legacy planning for all but the ultra wealthy is long-term care expenses. It is now estimated that a person living past age 65 has over a 70% chance of needing some form of LTC in their lifetime 1. With LTC costs soaring, planning for this risk makes sense, but makes even more sense to many clients when they can purchase coverage that pays a benefit whether they need LTC or not. An effective use of RMDs not otherwise needed for retirement income would be to purchase life insurance with a long-term care (LTC) rider. Should the insured have a qualifying long-term care event, this rider will allow the client to accelerate the death benefit while still living, tax free, to help pay the expenses of long-term care. But if LTC benefits are never needed or barely used, the remaining death benefit is paid to the beneficiary. Leveraging the IRA asset into a larger pool of money available tax free for LTC needs and/or for death benefit purposes will protect assets from being depleted if LTC should ever be needed. The end result is a larger inheritance for loved ones, whether long-term care is ultimately needed or not. Summary IRA distributions not needed for retirement needs or other strategies can be repurposed to enhance legacy planning or provide additional protection from LTC expenses. Using the after tax amount from unneeded RMD distributions to fund life insurance can create, with proper planning, a much more efficient inheritance to loved ones as well as a tax free opportunity to fund long-term care. The LTC rider is offered at an additional charge. It is possible for the LTC rider to offered on a rated basis, which may increase the premium illustrated. Also keep in mind that as an acceleration of the death benefit, the LTC rider payout will reduce both the death benefit and cash surrender values. Care should be taken to make sure that your clients' life insurance needs continue to be met even if the rider pays out in full. There is no guarantee that the rider will cover the entire cost for all of the insured's long-term care as these vary 1 USA Today, Do Retirees Need Long Term Care Insurance?, Sept.10,

5 with the needs of each insured. Inflation protection is not available, so the policy amount purchased today may not provide adequate funds for LTC expenses in the future. Please note that as your clients personal situations change (i.e., marriage, birth of a child or job promotion), so will their life insurance needs. Care should be taken to ensure these strategies and products are suitable for long-term life insurance needs. You should weigh your clients objectives, time horizon and risk tolerance as well as any associated costs before investing. Also, be aware that market volatility can lead to the possibility of the need for additional premium in the policy. Not all Nationwide products and services are suitable for all clients or situations. There may be products, issued by other companies, which better suit your clients goals. Be sure to consider your clients objectives, their need for cash flow and liquidity, and overall risk tolerance when using any strategy. The information in this material is for illustrative purposes only and is not intended as investment advice to you or your clients. You are solely responsible for determining the suitability of advice or recommendations you develop for your clients, including strategies that incorporate concepts or information presented in this material. This information was developed to promote and support products and services offered by Nationwide. It should not be taken as tax advice. It was not written or meant to be used by any taxpayer to avoid tax penalties, and it cannot be used by any taxpayer for that purpose. Federal income tax laws are complex and subject to change. The information in this memorandum is based on current interpretations of the law and is not guaranteed. Neither Nationwide, nor its employees, its agents, brokers or registered representatives gives legal or tax advice. You should consult an attorney or competent tax professional for answers to specific tax questions as they apply to your situation. Nationwide, the Nationwide N and Eagle and Nationwide is on your side are service marks of Nationwide Mutual Insurance Company Nationwide. Nationwide Investment Services Corporation, member FINRA. NFM-10565AO.3 5