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IRAs

Retirees, Buy Life Insurance to Help Your Heirs Pay Bills

Using required IRA distributions to buy life insurance can provide heirs a tax-free windfall, but the strategy isn't for everyone.

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Starting the year you reach age 70 1/2, you are required to take a distribution from your traditional IRA every year. But what if you don't need the money and would like to maximize a payout for your heirs?

See Also: SLIDE SHOW: 10 Things You Must Know About Traditional IRAs

You can buy a life insurance policy with a guaranteed death benefit and set aside your required minimum distributions to pay for premiums. "Clients want to create certainty that their legacy will happen -- they want a contract guarantee," says David Simbro, a senior vice-president at Northwestern Mutual. Your heirs will inherit life insurance proceeds free of income tax, and if your estate is large enough to be hit by federal estate tax, you can do some planning so that the insurance proceeds avoid that tax, too.

But there are drawbacks to this strategy. You need to consider whether the money you will pay in premiums might be needed for other expenses -- such as unexpected medical bills. If your RMD in some years won't cover the annual premium, you would either have to take a larger distribution from the IRA -- and pay a larger income-tax bill -- or use other assets.

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Generally, you need to buy a universal or whole-life policy, which builds up cash value. "You want a policy that will last as long as you do," says Deana Arnett, a certified financial planner with Rosenthal Wealth Management Group, in Manassas, Va. But, she says, those types of policies are more expensive than a term policy, which expires after a certain period.

Your age and health will factor into the premium costs, as will the amount of the death benefit you want, says Raymond Caucci, a senior vice-president at Penn Mutual Life Insurance, in Horsham, Pa. A 71-year-old man deemed a standard risk who wants a policy with a $1 million death benefit would pay about $40,000 a year in life insurance premiums, Caucci says.

If you will have a large taxable estate, you can hold the life insurance in a trust. When you die, the proceeds won't count toward the federal estate-tax exemption of $5.43 million ($10.86 million for a couple) in 2015. Seventeen states and the District of Columbia have either a state estate tax or inheritance tax (Maryland and New Jersey have both), and residents in states with lower exemptions than the federal threshold could benefit from the strategy.

The strategy could help retirees who have a lot of illiquid assets, such as real estate, that a family might prefer to keep, says David Walters, a certified financial planner with Palisades Hudson Financial Group, in Portland, Ore. Heirs could use the death benefit to pay estate-related and other expenses instead of dipping into the late benefactor's IRA.

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Run the Numbers

But before you buy insurance, consider investing instead. The 71-year-old above who is plunking down $40,000 a year on premiums might get a larger payoff by investing that amount every year. At a 5% annual return, he'd have about $1.2 million if he lives to age 88. His heirs would only owe income or capital-gains tax on appreciation after the date of the benefactor's death.

Advocates of the life insurance approach argue that beneficiaries could use the proceeds to pay the taxes on distributions from their inherited IRAs. Also, having the extra pot of money could encourage nonspouse beneficiaries to take RMDs based on their life expectancies rather than making large withdrawals to pay expenses, perhaps to send a child to college.

But you don't necessarily need life insurance proceeds to achieve these ends. If the benefactor puts his, say, $40,000 a year in a brokerage account, the heir could use that money for expenses and would be able to "stretch" the IRA over a lifetime. "The stretch makes it so the IRA doesn't have to be liquidated," Arnett says.

A 45-year-old's first required distribution would be about $26,000 from a $1 million inherited traditional IRA. Assuming a 25% tax rate, she'd pay about $6,500 in income tax on the withdrawal -- which she could pay from the brokerage account.