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Utilizing Life Insurance as a Tax-Efficient Inheritance Tool

While necessary to support our current economy in response to the COVID-19 pandemic, the recent government stimulus programs are adding to the already excessive U.S. federal deficit and may ultimately be one of the factors that forces Congress to increase tax rates in the future. 

Allegiant's Wealth Advisor Team provides a different perspective on passing a pre-tax inheritance to grown children who are themselves already in high tax brackets: utilizing life insurance as a tax-efficient inheritance tool.

As a reminder, the SECURE Act became law on December 20, 2019, and eliminated stretch IRA provisions. Stretch IRAs (pre-tax), when passed to non-spousal beneficiaries, allowed the beneficiary to withdraw the IRA assets over their lifetime. This is no longer possible. The new law states that non-spousal beneficiaries will have to recognize the entire account balance as taxable income over 10 years, following the death of the original account owner.

Let's assume Peggy is a 60-year-old client looking to pass on her $2-million-dollar traditional IRA (pre-tax) account to her 30-year-old daughter, Diane.

Diane is a Vice President at a national company and earns roughly $500,000 annually. The question begs how Peggy can tax-efficiently pass an inheritance to Diane without pushing Diane into a higher tax bracket.

As Peggy's plan stands currently, her daughter Diane's net IRA inheritance would likely be subject to the 37% tax bracket (per current law) plus her state tax rate (if applicable). Depending on future tax rate increases, Diane may receive even less of her mom's IRA inheritance.

To lower Diane's inheritance tax liability, one possible method Peggy could employ would be purchasing a life insurance policy and using the pre-tax IRA dollars to pay for the premiums. Peggy would be intentionally spending down her own IRA while simultaneously accomplishing two important goals: first, diminishing the overall tax impact upon inheritance and second, leveraging her current dollars to leave more to Diane.

The death benefit of a life insurance policy, in most cases, is passed to the beneficiary tax-free. This could accomplish the goal of leaving money in a tax-efficient manner, particularly to someone like Diane, already in a high-income tax bracket.

Peggy will have to consider the cost of the life insurance premiums, however. Among other factors, life insurance premiums are calculated based on age, total death benefit, tobacco use, and the overall health of an applicant. Should the applicant be unhealthy, for instance, life insurance premiums will likely not be cost-effective relative to the death benefit.

Peggy will also have to consider that this should be a lifelong commitment to paying these premiums, because paying for even as long as 7-8 years may not be enough to fully fund the policy for her entire expected life span, and not paying the premiums would probably mean that the policy terminates early, without paying out any death benefit or cash value. These factors are all considered by our Wealth Advisors when we discuss this extremely effective but complex solution with our clients.

Overall, leveraging the death benefit from a life insurance policy may be a fantastic method to pass an inheritance tax-free to a loved one. However, keep in mind that each individual and family situation is unique and this strategy may not make sense for everyone. If you have questions and want to review your individual plan, please contact an Allegiant Wealth Advisor.

This is a hypothetical example and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results.

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