Don't Let Tax Concerns Keep You From Taking Care of Loved Ones

Regardless of how much money you’ve put away for retirement, the goal once you get there is to keep as much of it as possible. For you, for as long as you’re around. For your spouse after you’re gone. And, eventually, for your kids, if that’s possible.

Most people say they want to leave something behind for their loved ones, but few put much thought into how they'll do it — or what the tax consequences could be for them or their beneficiaries. Many people forget, for instance, that if most of their nest egg is in a traditional IRA, Uncle Sam is going to want a share of that money, too.

But it’s never too late to make a plan to protect your nest egg now and pass on what you can later without losing thousands of dollars to taxes.

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Consider two hypothetical cases:

Hypothetical Case No. 1

The first is a 72-year-old single woman who wants to pass on her $270,000 traditional IRA to her kids in a way that it wouldn’t become a tax burden.

One option is to do a Roth conversion that would cost her approximately $90,000 in taxes. This option creates a tax-free account that her heirs would need to still take RMDs from each year but would not be taxable.

A second option is a bit more complicated, but it would give her some very different results. The woman could use her $270,000 IRA to buy a principal-protected annuity that would pay out $15,000 a year for the rest of her life and, going forward, would qualify as her annual required minimum distribution (RMD). In this hypothetical we’re going to assume the $15,000 would be taxable at approximately 30%, leaving her $10,500 a year to spend. And she could use that $10,500 to pay the premium on a $370,000 life insurance policy with a tax-free payout.

The result is when she dies, her children will get what’s left in her IRA plus the $370,000 tax-free insurance money, which they can use to pay the taxes on the IRA distributions.

Hypothetical Case No. 2

The second example is someone with $2.5 million in his IRA. He is 68 years old and his wife is 65. His major concern is if he dies first, his wife wouldn’t receive his $10,000 monthly pension due to the plan policies. He is also worried because she would move to a higher tax bracket as a single filer.

Taking both issues into consideration, what would be the results of putting his IRA into a principal-protected annuity that guarantees a payout of $100,000 a year for life for them both? If the $100,000 is taxable at approximately 30%, that leaves $70,000 a year. We could use $30,000 of the after-tax money for a $1 million life insurance policy, leaving $40,000 to spend.

At the end of 10 years, if the principal-protected product’s index performs well, the couple could receive approximately $200,000 per year in lifetime payments. That amount isn’t guaranteed, but if it happens, let’s assume $200,000 would be taxable at approximately 35%, leaving $130,000 a year to spend. If they continued to use $30,000 a year to pay for the $1 million life insurance policy, they’d have $100,000 left to spend.

And if the gentleman dies first, his wife can use the $1 million life insurance policy to convert the remainder of the traditional IRA to a Roth IRA, which would make future payments tax-free. This result solves both concerns for him in a way that allows her to collect the income from the converted Roth IRA, replacing the pension income, without increasing her income tax as a single filer.

My Point: Go Beyond the Basics

I often describe these types of strategies, which use life insurance to create tax-free money for beneficiaries, as “pennies from heaven.” My clients, on the other hand, tend to call it “outside-the-box thinking.”

What it really is, though, is thinking about everything that should go into your box for retirement. You don’t have to stick with the same basic plans or products that most financial professionals offer.

Transforming your retirement into a legacy doesn’t have to be complicated. But it helps to work with an experienced adviser who knows how to safeguard your money in the present and help you make it last into the future.

Kim Franke-Folstad contributed to this article.