There are several tax savings strategies that can be used to transfer wealth. It’s important to plan ahead, however.
We will outline the most common strategies below for reducing taxes while maximizing the amounts available to your beneficiaries.
The most important factor in wealth transfer is planning ahead. Opportunities will be missed if the person(s) who wish to transfer their wealth have waited until they are in poor health or beyond certain age thresholds to take advantage of the time needed to put certain plans in place.
There are several factors that will needlessly reduce the size of an estate, but the most common ones are taxes and long term healthcare needs. Both can quickly reduce a nest egg and both can be avoided.
Taxes that will reduce estates significantly include: income taxes, federal estate taxes, and state inheritance/estate taxes. Large qualified retirement plans like IRA’s, 401(k)’s and 403(b)’s pose problems as many of these plans are subject to all three of the aforementioned taxes.
Medical care is harder to account for as it is almost always an unknown quantity. It’s hard to think far into the future when extended care might be needed. However, it is something that must be planned for ahead of time as little can be done at onset.
Despite what some pundits would have you believe, life insurance is one of the best investment vehicles for transferring wealth between generations and from person to person. When used properly, life insurance policies can bypass federal estate taxes, reduce income taxes, and in some states (like New Jersey and Pennsylvania) avoid state inheritance taxes.
There are no asset classes afforded such a favorable tax treatment as life insurance. Most importantly, these policies avoid income taxes when inherited by a beneficiary. This is true whether the proceeds are payable to a spouse, your children, a valued business partner or a favorite charity.
There are several types of life insurance, but the most common types used to transfer wealth are whole life and universal life. Typically term life insurance policies will not be used as they have an expiration date.
Forward looking individuals will setup life insurance policies while they are relatively young and in good health. Many times, life policies will also offer an option to purchase additional coverage with little or no underwriting in order to account for growing estates.
Many wealthy individuals have wisely been using life insurance policies as part of their estate planning to immediately provide needed, tax-free liquidity to their beneficiaries. Larger estates will oftentimes use an Irrevocable Life Insurance Trust so the policy would not be counted as part of the gross estate.
One common method of reducing sizable qualified IRA, 403(b) and 401(k) accounts to non-taxable investments is by way of annuitization.
This method can immediately liquidate the entire qualified account while creating a comparable (if not larger) income tax-free life insurance policy.
There are many methods to this strategy and one size does not fit all. In some cases, IRA owners will purchase an immediate lifetime annuity with all or a portion of their qualified account. The immediate annuity would have no cash value and would provide systematic payments and interest for the insured’s lifetime.
The systematic payments would be used to fund a tax-free universal or whole life insurance policy that could either be held in or outside of the estate. The life insurance policy would immediately create a sizable income tax-free death benefit that would be greater than the IRA account value.
The systematic lifetime (or defined yearly) payments would spread the income tax burden over several years. This can be much more advantageous than withdrawing the same funds in a lump sum or over a short period of time. It also relieves the burden of inheriting a large taxable account by one or more beneficiaries.
This method works best for those who have little or no need for all – or a portion of their – qualified account monies. The annuity would provide lifetime (or a certain yearly amount) of future payments, but would have no value at death while the life policy would immediately create a sizable death benefit providing tax-free proceeds to children or a spouse at passing.
Yet another method to reduce the size of a taxable retirement account is through a Roth IRA conversion. In this scenario, the account owner liquidates their traditional IRA over a set amount of time and converts those funds to a Roth IRA.
When liquidating a traditional IRA, all monies withdrawn will be taxed as ordinary income. Thus, income taxes cannot be avoided. However, funds in a Roth IRA grow tax free and can be withdrawn tax free by the owner or the owner’s beneficiaries.
The advantages of a Roth IRA conversion are that the owner retains control over their funds while also paying income taxes on his or her own terms. It looks like marginal tax rates will increase in the future, so using a Roth IRA conversion now to take advantage of lower tax rates may be the best strategy.
There is and always will be an ongoing debate as to whether purchasing long term care insurance is a wise financial move. The simple answer is that it may not be right for everyone. There are certainly reasonable arguments both for and against. It’s wise to think of LTC insurance plans as protection – not an investment.
What cannot be argued is that extended long term medical care is one of the most significant factors in estate reduction for those with moderate to above average wealth. Those with significant liquid assets may choose to self-insure, but most others cannot afford to do so.
In response to this dilemma, many insurance companies now market hybrid long term care insurance. These policies combines annuities and life insurance with long term care policies. Purchasing (or investing in) a hybrid long term care policy can eliminate the unknowns of potential lack of use and future premium increases.
In a nutshell, these plans are usually funded with in a lump sum. The owner retains control of the principal and can withdraw it at any point for other uses. If long term care is needed, the invested dollars will be leveraged several times over to pay for care. In this way, the policy owner gets a tangible investment while also leveraging these same funds for medical care.
When coupled with a life insurance policy, the hybrid LTCi owner will also have the advantage of passing dollars on to family on an income tax-free basis if the policy was never accessed for long term care coverage. Conversely, the interest growth in a hybrid annuity policy would still be taxable, but not if it’s withdrawn to cover LTC expenses.
We specialize in wealth transfer strategies and asset protection. Contact us today to discuss your financial needs and we can recommend strategies for minimizing taxes, accounting for long term care and efficiently passing wealth to your beneficiaries.
