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Life Insurance: The Solution to a Looming and Massive Wealth Transfer Tax Problem

Many people leave their retirement account balances to their children after they pass. They employ a strategy called “stretch” that allows the children to take the funds inherited over time (as measured by the beneficiaries’ life expectancy) so as not to pay the income tax all at once.

Fundamentally, the “stretch” strategy would continue to defer the taxes over the balance of the lifetime of our children regardless of whether the child dies prior to the life expectancy.

Tim Grant, in a December 10th article in the Pittsburg Post-Gazette provided an excellent example:

For example, assume a son inherits an IRA upon the death of his father in 2016. The son will turn 53 in 2017, when required distributions based on his life expectancy commence. The IRA Single Life Expectancy Table indicates that at age 53, the son has a 31.4-year life expectancy. In 2017, the son's required minimum distribution amount, which he would be required to pay taxes on, would be computed as follows: The balance of his inherited account on Jan. 1, 2017, times the fraction 1/31.4. For the years after 2017, the son reduces his life expectancy by one year from what it was in 2017. So in 2018, his required minimum distribution fraction is 1/30.4. This minimum required distribution fraction applies to the son's inherited IRA even if the son dies. The Internal Revenue Service really doesn't care who the account passes to at that point, since it has no effect on the required minimum distribution rate from the inherited IRA, which was set in 2017.

But the popular “stretch” strategy is currently under fire by the Senate Committee on Finance.

In September of 2016, just five months ago, the Committee voted 26-0 on a proposal to kill the ability for taxpayers to “stretch” their IRAs inter-generationally. The proposal, which applies only to non-spousal beneficiaries, offers an exclusion of $450,000, so any accounts over that amount would be subject to a more accelerated tax. The proposal would also require the taxes be paid within a 5-year period.

Let’s dig deeper into what that means financially…

The Investment Company Institute (ICI) estimated that as of June 2016 there were retirement assets in the United States of $24.5 trillion. In a 2014 Government Accountability Office report, which is show below, data was provided on the estimated number of IRAs and a range of balances in those accounts.

While not law yet…let's look at the reality. For simplicity sake, if we took out the bottom half of the accounts in the $0 to $1,000,000 cell in the above table, basically cutting that number in half, the total untaxed amount of IRA assets over the $450,000 exclusion would approach $12 TRILLION.

Taxing this in a more accelerated fashion than they can today is a very attractive way to reduce deficits on the backs of the taxpayers who had diligently saved for retirement. Tax revenue at 40% would be almost $5 TRILLION or over one quarter of our current total national debt! Currently, Congress has to potentially wait many years to get their tax revenue on these assets.

So, what's an alternative to the "stretch" strategy?

For those of you who are proponents of the benefits of cash value life insurance, permanent (cash value) life insurance, while not tax deductible, offers cash value growth tax deferred and can be accessed tax free if structured properly. Furthermore, amounts passed on to heirs are tax free. So in short, life insurance could be the solution to this looming and massive wealth transfer tax problem.

That does not mean, however, that in the future, Congress could equally decide that they are going to tax it either during life or at death.

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