Individual retirement accounts (IRAs) are one of the primary ways people save for retirement. But is there a better way? IRAs may be subject to both estate tax and income taxes on your death. It is possible to leave more money to your heirs by buying life insurance with IRA money
Life insurance proceeds pass to your heirs tax free (generally) and can help alleviate the issues of required minimum distributions (RMDs) and the pending ‘tax bomb’ of a large qualified asset portfolio.
You can fund life insurance with money in place of making more qualified distributions to your IRA or you can use your IRA withdrawals in retirement to pay for life insurance. In both cases you are shifting your tax burden forward to avoid large taxes for you and your beneficiaries later.
However, you can not directly buy life insurance within your IRA.
Life insurance is complex and it can be controversial. Many people think life insurance is a waste of money and countless others are big proponents of life insurance.
We have previously laid out 15 reasons to buy life insurance. And here is a way to use your IRA to buy life insurance that may be beneficial to you.
Key Takeaways:
- Most Americans use qualified retirement accounts like traditional IRAs and 401ks to fund their retirements
- However, by deferring taxes on your largest source of retirement, you are setting up for an unknowable ‘tax bomb’ when you enter your retirement drawdown phase
- Life insurance may be an alternative that allows for you to build a retirement nest egg and leave an inheritance to your heirs while diversifying and avoiding some long-term tax risk.
Buying Life Insurance With IRA Money
Taxes are one of the biggest concerns in retirement. Qualified retirement plans like 401ks and traditional individual retirement accounts (IRAs) are a great way to save for retirement. However, by putting in money pre-tax and growing it tax deferred, you leave yourself with a large and unknown tax bill in retirement.
There is a solution.
You can use life insurance to help with your qualified money.
There are 2 ways you can do this. First, before retirement you can purchase a life insurance policy and fund it with some of the money you were going to put into a traditional IRA or 401k. If you are a high earner, you may max out both your trad IRA and 401k and then decide to save even more with life insurance too.
Second, if you are already retired, you can use withdrawals from your IRA to fund a life insurance policy. You can do this before the age 72 required minimum distribution (RMD) age or wait till you need to take RMDs and use some of that money for insurance premiums.
Taxes And The Problem With IRAs
Traditional IRAs can be a sitting ‘tax bomb’. As you contribute pre-tax money and it grows tax-deferred, you can wind up with a large tax liability come retirement time.
Additionally, your future tax rate is unknown. Congress sets tax rates, and a future government could significantly increase rates. If your tax rate doubled in retirement, your nest egg may be less than you planned.
And required minimum distributions (RMDs) force withdrawals in your early 70s, ending your ability to continue to defer tax payments.
Overall, there are 2 different tax concerns with IRAs in retirement.
- Taxes on withdrawals while living
- Taxes on assets when you die
When you die, assets in retirement accounts become “income in respect of a decedent”. These assets do not receive a ‘step-up’ cost basis when passing to your beneficiary, unlike many other assets. For example, assets in taxable accounts that have appreciated in value generally get passed to your beneficiary at a stepped-up fair market value and avoid separate taxes on the gains.
Your beneficiary receives the distributions as part of their gross income and will be subject to their ordinary income tax. The result is significantly less money left to your loved ones than you thought.
Life Insurance Can Fix IRA Tax Issues
There is a way to improve your tax situation that a high IRA balance creates, life insurance.
Many people who reach 70.5 years old are forced to withdraw more money than they want because of RMDs. But you can use life insurance to avoid much of this by using the after-tax distributions from your IRA to pay the life insurance premiums.
[Professor B.T. Effer Note – with the passage of the SECURE Act and the SECURE Act 2.0, the RMD age has been increased to 73 and will further increase to 75 in the future.]
The benefit of doing this is in the tax-advantaged nature of life insurance’s death benefit. After the IRA owner dies, the life insurance proceeds can help pay estate tax and other expenses associated with death. This saves the beneficiary from having to handle these costs.
The end result is for wealth to be built up in the life insurance policy instead of a ‘tax bomb’ IRA. And even if you find out later you need to access the money, there is liquidity in permanent life insurance policies. You can access your cash value or take a loan against your policy. (Note – there are pros and cons to accessing the cash in a life insurance policy, so discuss the decision with your financial advisor).
Benefits of Life Insurance Over an IRA
There are many benefits to using life insurance in retirement:
- Can access liquidity in your life insurance policy if you need additional retirement income
- No RMDs
- Limited market risk as many permanent insurance policies have guaranteed minimum growth rates and are not dependent on stock market performance
- Death benefit is usually tax-free to your beneficiaries
- Death benefits avoid probate
- Can utilize life insurance’s spendthrift clause to control inheritance and protect beneficiaries.
Downsides of Using Life Insurance Instead of IRA
There are some downsides to using life insurance in retirement over an IRA:
- Income tax is paid when you take your RMD
- Life insurance is costly to cancel so your funds are tied up until you die
- If you need to access your money, there is likely withdrawal charges
- Withdrawals may reduce your death benefit
- Life insurance premiums are made with after-tax money so no immediate tax savings for contributing
- High fees
- May have limited upside exposure to stock market depending on the type of life insurance policy chosen.
Using life insurance in retirement requires a long-term plan and a focus on your estate. It can be mentally difficult for a person drawing down or nearing retirement to tie up funds they are concerned they may need.
The Final Word
IRAs and other traditional retirement accounts can be powerful tools to save for retirement. However, they aren’t risk free and leave a large unknown tax liability for you when you go to access your money.
Life insurance is funded with after-tax money, but allow for tax efficient use of your fund and a largely tax-free death benefit for your heirs.
It is important to compare both life insurance vs a trad IRA and life insurance vs a Roth IRA as the tax implications are different.
By using some of your IRA money to fund a life insurance policy, you can diversify your tax risk and potentially lower you future tax burden.
Frequently Asked Questions (FAQs):
Traditional retirement accounts allow you to contribute money pre-tax and grow it tax deferred. However, when you withdraw the money you get taxed on it. The downside of using these accounts is that you don’t know what your future tax rate will be.
By deferring taxes, you are leaving yourself with a ‘tax bomb’ come retirement and may result in having significantly less money than you planned.
There are many benefits to using IRA money to purchase life insurance instead. These include:
1) Can access liquidity in your life insurance policy if you need additional retirement income
2) No RMDs
3) Limited market risk as many permanent insurance policies have guaranteed minimum growth rates and are not dependent on stock market performance
4) Death benefit is usually tax-free to your beneficiaries
5) Death benefits avoid probate
6) Can utilize life insurance’s spendthrift clause to control inheritance and protect beneficiaries
Purchasing life insurance is taking a long-term view and ties up your money so you should consult a financial advisor to make sure it is the correct decision for you.
Buying life insurance with your IRA money has many tax-advantages for you and your heirs. However, there are some downsides that include:
1) Income tax is paid when you take your RMD still
2) Life insurance is costly to cancel so your funds are tied up until you die
3) If you need to access your money, there is likely withdrawal charges
4) Withdrawals may reduce your death benefit
5) Life insurance premiums are made with after-tax money so no immediate tax savings for contributing
6) Life insurance has high fees
7) May have limited upside exposure to stock market depending on the type of life insurance policy chosen.
Overall, you are taking a long-term view and shifting your taxes forward to save your beneficiaries taxes in the future. You should consult your financial advisor to ensure this strategy fits into your financial plan.