IRA or Life Insurance: Which to Use for Leaving Wealth to Your Heirs?

By Clifton Linton
Senior Writer, mPower

In This Story Probate and Taxes Traditional IRAs Roth IRAs Life Insurance Irrevocable Life Insurance Trusts (ILIT)

After you die, taxes can sap the value of your estate assets. Under certain circumstances, Uncle Sam can end up taking 70 percent of the assets intended for your heirs. As IRA balances grow ever bigger — from years of interest compounding, capital gains, and rollovers from defined-contribution plans — the question of whether IRAs are good tools for passing on your assets becomes more pressing.

Although this is by no means a comprehensive list, here's a look at how you can use traditional and Roth IRAs, a life insurance policy or a combination to bequeath your assets as you see fit.

minute: read this article at a glance.

Historically, family wealth has been concentrated in real estate, with a family's home typically being its largest asset. Yet, from 1989 to 1998, the last year for which statistics are available, the value of American families' financial assets rose at a faster rate than nonfinancial assets, the Federal Reserve Board reported in the Jan. 2000 Federal Reserve Bulletin.

Technical Terms Beneficiary Probate Roth IRA

In 1998, retirement accounts represented 27.5 percent of families' wealth and houses represented 47.1 percent. In 1989, retirement accounts made up 21.5 percent of families' wealth, while houses made up 45.9 percent of wealth.

The enormous growth of IRA assets (in 1999, IRA assets are expected to reach $2.4 trillion, the Employee Benefit Research Institute estimates, up from $546 million in 1989) is creating new issues for retirees to consider: Should baby boomers and other future retirees leave their money in their IRAs and pass on those accounts to their heirs? Should they use an alternative tool such as life insurance? Or, should they try a combination of the two? Each one has estate-planning advantages and disadvantages, and in some circumstances a combination may be best. Of course there are also other tools available, but they are so specialized and sophisticated that they are outside of the scope of this article.

Here are some ideas to think about as you make your plans.

Probate and Taxes

When you think about your estate, regardless of its composition, look at it as a series of concentric circles, advises Mari Adam, a certified financial planner in Boca Raton, Fla.

The smallest circle is the probate estate. Included in this category are houses, brokerage accounts, personal possessions and cash on hand. The disposition of these assets is dictated by your will.

The next largest circle includes the taxable estate. This includes everything in the probate estate plus beneficiary-designated assets such as IRAs and life insurance policies. The advantage of passing on an asset through beneficiary designation is that it doesn't have to go through the potentially costly and time-consuming probate process.

When the IRS calculates the tax owed on an estate, it counts all the elements in the probate and taxable estate circles.

The next largest circle includes assets held outside the estate in trusts. These assets, which aren't controlled by the individual, are not counted in the estate tax bill.

Estate taxes can be quite costly. They don't kick in, however, until your estate reaches $675,000. At that point, the tax is levied at a 37 percent rate. The tax rate escalates as your estate value grows and tops out at 55 percent if your estate is worth $3 million or more.

A presidential veto killed a congressional move to repeal the estate tax in 2000, and a future repeal isn't a political certainty. So, proper estate planning is crucial if you want a say in how your assets are ultimately distributed.

Here are the basics of how a traditional IRA, Roth IRA, life insurance plan, and an Irrevocable Life Insurance Trust (ILIT) behaves when passed on to your heirs.

Traditional IRAs

What it is: An account into which you may make tax-deductible or nondeductible contributions that can later be withdrawn at retirement. At the time of withdrawal, income tax is assessed on the original contribution (if it was tax-deductible) and profits on those contributions.

Estate-planning pros:

• Avoids probate.
• Heirs may be able to extend the IRA withdrawals, allowing the balance to continue to grow tax-deferred.
• Available to every worker, although deductible contributions are not permitted for workers who reach the IRS salary cap while participating in an employer-sponsored defined-contribution plan. Anyone with earned income may make a nondeductible contribution, however.

Estate-planning cons:

• Subject to estate tax.
• Has rigid withdrawal rules, which can affect both the IRA holder and beneficiaries. Read Avoid Expensive Mistakes When Making IRA Beneficiary, Distribution Choices for more on this topic.
• Withdrawals by both IRA holder and beneficiaries are subject to income tax. Further, the assets held in an IRA are not revalued at the time of death, as are stocks, houses or bonds.
• Heirs may find themselves in a liquidity trap, says estate attorney Jean Dragon of the Hoopis Financial Group, based in Northfield, Ill. If an IRA comprises the majority of an estate and the heirs don't have other resources, they may have to liquidate the account to pay the estate taxes. When the IRA is liquidated, the heirs will then have to pay income tax on the withdrawal, which itself may put them into a higher tax bracket.

What's a "Liquidity Trap"? Suppose your father died, leaving you an estate of $3 million, all in an IRA. The estate tax rate on the account would be 55 percent, resulting in a tax bill of $1.65 million. Unless you had other resources to pay the taxes, you would have to liquidate a portion of the IRA to provide the funds. In doing so, your annual income would rise by $1.65 million, pushing you into the 39.6 percent tax bracket, regardless of your filing status. Consequently, you would owe a tax of $653,400 on the withdrawal. The total tax bill would be $2.303 million, more than 70 percent of the IRA balance.

When to use it: Ideal tool for passing assets on to a spouse. A spouse can roll an inherited IRA into his or her own IRA and make a new set of beneficiary and withdrawal choices.

How to use it: Avoid naming an estate as an IRA beneficiary. The reason: Your heirs will lose the ability to draw out withdrawals over time. All the money will have to be withdrawn by the end of the year following the year of death.

To reduce their tax bill, heirs can itemize the estate and income taxes paid on inherited IRAs in the year that they must pay those taxes.

Roth IRAs

What it is: A tax-deferred savings account funded with after-tax contributions. All contributions grow tax-deferred, and withdrawals are income-tax free provided you follow the rules. And, a Roth IRA gives beneficiaries more flexibility than a traditional IRA in terms of spreading out the distributions (and the resulting taxes) over time.

Estate-planning pros:

• More flexible withdrawal rules than traditional IRAs.
• Avoids probate.
• Distributions are income-tax free to holders and heirs if they follow the rules. Heirs can avoid an income tax liquidity trap.

Estate-planning cons:

• Subject to estate tax.
• Defined-contribution balances can't be rolled directly into a Roth. Money must be first placed in a traditional IRA and then converted to a Roth. Conversion from a traditional to a Roth IRA may be costly in terms of taxes owed.
• You must meet income eligibility rules in order to either open a new Roth or make a conversion.

When to use:

• When you or your heirs want to have a source of tax-free income in your estate.
• You can partially or fully convert a traditional IRA to a Roth IRA and reduce your taxable estate. When you convert a traditional IRA to a Roth, you must pay the tax on the original contribution and any profits earned. The tax payments can reduce the value of your estate.

Life Insurance

Setting up a life insurance policy is another way to pass on a large sum of money to your heir(s). You should talk with an estate lawyer or financial planner to figure out how a life insurance policy can be a useful estate-planning tool for you.

What it is: Risk protection against an individual's life.

Estate-planning pros:

• Avoids probate.
• Benefits are income-tax free to your heirs.
• Some policies include savings features. The holder may be able to borrow the savings against the value of the policy.
• Because benefits are paid in cash and are tax-free, heirs can avoid the income tax liquidity trap that traditional IRAs can create.

Estate-planning cons:

• Subject to estate tax.
• Some policies may be costly.
• Some policies may be difficult to understand.

When to use: When trying to protect an heir's ability to pay the tax bill on your estate. They can also give you some flexibility in deciding how to disburse your IRA money.

Irrevocable Life Insurance Trusts (ILIT)

What it is: A way to use the benefits of a life insurance policy to pay the taxes that might be owed on your estate. This trust is held outside both the probate and taxable portions of the estate.

An ILIT is set up so that the trust is both the owner and beneficiary of a life insurance policy on the worker or retiree. Typically, the worker makes a monetary gift to the trust's trustee, who in turn pays the premiums on the policy. At death, the life insurance benefits are paid to the trust. The trustee may lend the benefits to the estate to pay the estate taxes or may buy assets from the estate.

Estate-planning pros:

• Not part of the probate estate.
• Benefits are not part of the taxable estate.
• Beneficiaries don't have to pay income tax on benefits.

Related Reading Avoid Expensive Mistakes When Making IRA Beneficiary, Distribution Choices The Roth IRA: A Useful Estate-planning Tool

Estate-planning cons:

• The insured won't be able to borrow against the value of the life insurance policy or change the beneficiaries.
• Requires an attorney's help to set up.

When to use: When your estate is valued at more than $675,000 and you want to reduce the tax liability of your heirs. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

IRA or Life Insurance: Which to Use for Leaving Wealth to Your Heirs?

By Clifton Linton
Senior Writer, mPower

In This Story Probate and Taxes Traditional IRAs Roth IRAs Life Insurance Irrevocable Life Insurance Trusts (ILIT)

After you die, taxes can sap the value of your estate assets. Under certain circumstances, Uncle Sam can end up taking 70 percent of the assets intended for your heirs. As IRA balances grow ever bigger — from years of interest compounding, capital gains, and rollovers from defined-contribution plans — the question of whether IRAs are good tools for passing on your assets becomes more pressing.

Although this is by no means a comprehensive list, here's a look at how you can use traditional and Roth IRAs, a life insurance policy or a combination to bequeath your assets as you see fit.

minute: read this article at a glance.

Historically, family wealth has been concentrated in real estate, with a family's home typically being its largest asset. Yet, from 1989 to 1998, the last year for which statistics are available, the value of American families' financial assets rose at a faster rate than nonfinancial assets, the Federal Reserve Board reported in the Jan. 2000 Federal Reserve Bulletin.

Technical Terms Beneficiary Probate Roth IRA

In 1998, retirement accounts represented 27.5 percent of families' wealth and houses represented 47.1 percent. In 1989, retirement accounts made up 21.5 percent of families' wealth, while houses made up 45.9 percent of wealth.

The enormous growth of IRA assets (in 1999, IRA assets are expected to reach $2.4 trillion, the Employee Benefit Research Institute estimates, up from $546 million in 1989) is creating new issues for retirees to consider: Should baby boomers and other future retirees leave their money in their IRAs and pass on those accounts to their heirs? Should they use an alternative tool such as life insurance? Or, should they try a combination of the two? Each one has estate-planning advantages and disadvantages, and in some circumstances a combination may be best. Of course there are also other tools available, but they are so specialized and sophisticated that they are outside of the scope of this article.

Here are some ideas to think about as you make your plans.

Probate and Taxes

When you think about your estate, regardless of its composition, look at it as a series of concentric circles, advises Mari Adam, a certified financial planner in Boca Raton, Fla.

The smallest circle is the probate estate. Included in this category are houses, brokerage accounts, personal possessions and cash on hand. The disposition of these assets is dictated by your will.

The next largest circle includes the taxable estate. This includes everything in the probate estate plus beneficiary-designated assets such as IRAs and life insurance policies. The advantage of passing on an asset through beneficiary designation is that it doesn't have to go through the potentially costly and time-consuming probate process.

When the IRS calculates the tax owed on an estate, it counts all the elements in the probate and taxable estate circles.

The next largest circle includes assets held outside the estate in trusts. These assets, which aren't controlled by the individual, are not counted in the estate tax bill.

Estate taxes can be quite costly. They don't kick in, however, until your estate reaches $675,000. At that point, the tax is levied at a 37 percent rate. The tax rate escalates as your estate value grows and tops out at 55 percent if your estate is worth $3 million or more.

A presidential veto killed a congressional move to repeal the estate tax in 2000, and a future repeal isn't a political certainty. So, proper estate planning is crucial if you want a say in how your assets are ultimately distributed.

Here are the basics of how a traditional IRA, Roth IRA, life insurance plan, and an Irrevocable Life Insurance Trust (ILIT) behaves when passed on to your heirs.

Traditional IRAs

What it is: An account into which you may make tax-deductible or nondeductible contributions that can later be withdrawn at retirement. At the time of withdrawal, income tax is assessed on the original contribution (if it was tax-deductible) and profits on those contributions.

Estate-planning pros:

• Avoids probate.
• Heirs may be able to extend the IRA withdrawals, allowing the balance to continue to grow tax-deferred.
• Available to every worker, although deductible contributions are not permitted for workers who reach the IRS salary cap while participating in an employer-sponsored defined-contribution plan. Anyone with earned income may make a nondeductible contribution, however.

Estate-planning cons:

• Subject to estate tax.
• Has rigid withdrawal rules, which can affect both the IRA holder and beneficiaries. Read Avoid Expensive Mistakes When Making IRA Beneficiary, Distribution Choices for more on this topic.
• Withdrawals by both IRA holder and beneficiaries are subject to income tax. Further, the assets held in an IRA are not revalued at the time of death, as are stocks, houses or bonds.
• Heirs may find themselves in a liquidity trap, says estate attorney Jean Dragon of the Hoopis Financial Group, based in Northfield, Ill. If an IRA comprises the majority of an estate and the heirs don't have other resources, they may have to liquidate the account to pay the estate taxes. When the IRA is liquidated, the heirs will then have to pay income tax on the withdrawal, which itself may put them into a higher tax bracket.

What's a "Liquidity Trap"? Suppose your father died, leaving you an estate of $3 million, all in an IRA. The estate tax rate on the account would be 55 percent, resulting in a tax bill of $1.65 million. Unless you had other resources to pay the taxes, you would have to liquidate a portion of the IRA to provide the funds. In doing so, your annual income would rise by $1.65 million, pushing you into the 39.6 percent tax bracket, regardless of your filing status. Consequently, you would owe a tax of $653,400 on the withdrawal. The total tax bill would be $2.303 million, more than 70 percent of the IRA balance.

When to use it: Ideal tool for passing assets on to a spouse. A spouse can roll an inherited IRA into his or her own IRA and make a new set of beneficiary and withdrawal choices.

How to use it: Avoid naming an estate as an IRA beneficiary. The reason: Your heirs will lose the ability to draw out withdrawals over time. All the money will have to be withdrawn by the end of the year following the year of death.

To reduce their tax bill, heirs can itemize the estate and income taxes paid on inherited IRAs in the year that they must pay those taxes.

Roth IRAs

What it is: A tax-deferred savings account funded with after-tax contributions. All contributions grow tax-deferred, and withdrawals are income-tax free provided you follow the rules. And, a Roth IRA gives beneficiaries more flexibility than a traditional IRA in terms of spreading out the distributions (and the resulting taxes) over time.

Estate-planning pros:

• More flexible withdrawal rules than traditional IRAs.
• Avoids probate.
• Distributions are income-tax free to holders and heirs if they follow the rules. Heirs can avoid an income tax liquidity trap.

Estate-planning cons:

• Subject to estate tax.
• Defined-contribution balances can't be rolled directly into a Roth. Money must be first placed in a traditional IRA and then converted to a Roth. Conversion from a traditional to a Roth IRA may be costly in terms of taxes owed.
• You must meet income eligibility rules in order to either open a new Roth or make a conversion.

When to use:

• When you or your heirs want to have a source of tax-free income in your estate.
• You can partially or fully convert a traditional IRA to a Roth IRA and reduce your taxable estate. When you convert a traditional IRA to a Roth, you must pay the tax on the original contribution and any profits earned. The tax payments can reduce the value of your estate.

Life Insurance

Setting up a life insurance policy is another way to pass on a large sum of money to your heir(s). You should talk with an estate lawyer or financial planner to figure out how a life insurance policy can be a useful estate-planning tool for you.

What it is: Risk protection against an individual's life.

Estate-planning pros:

• Avoids probate.
• Benefits are income-tax free to your heirs.
• Some policies include savings features. The holder may be able to borrow the savings against the value of the policy.
• Because benefits are paid in cash and are tax-free, heirs can avoid the income tax liquidity trap that traditional IRAs can create.

Estate-planning cons:

• Subject to estate tax.
• Some policies may be costly.
• Some policies may be difficult to understand.

When to use: When trying to protect an heir's ability to pay the tax bill on your estate. They can also give you some flexibility in deciding how to disburse your IRA money.

Irrevocable Life Insurance Trusts (ILIT)

What it is: A way to use the benefits of a life insurance policy to pay the taxes that might be owed on your estate. This trust is held outside both the probate and taxable portions of the estate.

An ILIT is set up so that the trust is both the owner and beneficiary of a life insurance policy on the worker or retiree. Typically, the worker makes a monetary gift to the trust's trustee, who in turn pays the premiums on the policy. At death, the life insurance benefits are paid to the trust. The trustee may lend the benefits to the estate to pay the estate taxes or may buy assets from the estate.

Estate-planning pros:

• Not part of the probate estate.
• Benefits are not part of the taxable estate.
• Beneficiaries don't have to pay income tax on benefits.

Related Reading Avoid Expensive Mistakes When Making IRA Beneficiary, Distribution Choices The Roth IRA: A Useful Estate-planning Tool

Estate-planning cons:

• The insured won't be able to borrow against the value of the life insurance policy or change the beneficiaries.
• Requires an attorney's help to set up.

When to use: When your estate is valued at more than $675,000 and you want to reduce the tax liability of your heirs. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.