How to Pass Money To Heirs Tax-Free. An Often Overlooked Way To Do It. – Cravitz Financial & Insurance Solutions

How to Pass Money To Heirs Tax-Free. An Often Overlooked Way To Do It.

Video Transcript:

How's it going everybody? It's Ryan here.

All right. I want to share with you a particular financial concept or solution, perhaps I should say. This is based upon a client that I'm working with this week. Now, I'm not going to go through all the different areas of planning that we're doing, I just want to highlight one particular component of it.

I'm also not going to name my client's name. I also changed some of the details around a little bit, but basically, here's the situation. She's 65. She's single. She has three sons. They're all doing fairly well financially.

And for her, for retirement, as far as her income sources and assets and such, she has Social Security, that she's going to be able to turn on, but she's probably not going to turn that on until she's 70. At least that's the plan so far.

And she's got an IRA, which is pretty sizable, and she has some cash in a savings account. So it's still sitting there from a sale of a second home.

Here's the thing. Her IRA, again, it's pretty sizeable. Chances are, she's going to have more money than she's going to need to live on during her lifetime. So we know what her budget is, we know the lifestyle that she wants to be able to maintain, and based on our projections and such, she's going to have more money than she's going to need.

Now, again, one of her goals is to make sure that, not only that she has enough money for her lifetime to live on, but also that she can leave some money to her sons. Now, one way to go about that is, she could spend what she wants to spend.

Then whatever's remaining just goes to her sons when she does pass away. Certainly one way to do it. I asked her, though, I said, "Is there a particular amount of money, or anything specific that you want to make sure that you leave behind for them?" And instantly she knew. It was $300,000. It was $100,000 to each of her three sons.

Really, it was for her sons, but they're fairly well to do, but it was really for her grandkids. So she wanted the money to go to her kids, with the intention that they would basically spoil her grandkids was really the idea.

So, to back up, what is she doing right now for income? Again, she's going to delay Social Security until 70, at least that's the plan. She's taking money out of her IRA right now to satisfy her living expenses. And primarily, that's it.

She could be taking money from her cash account, and not have to pay any cash, and not have to pay any taxes on that. But eventually, she's going to have to start paying taxes on the IRA. So we want to spread those taxes out over the course of her retirement.

Remember, you don't have to start taking out required minimum distributions from an IRA until 72 now, because of the Secure Act that got passed last year. It's 2020 now, it was passed at the end of 2019. By the way, because of the CARES Act earlier this year, nobody has to take out an RMD in the year 2020.

But going forward for her, at age 72, she'll be required to have to start taking it out. So instead of just letting that IRA continue to grow, and then have to be required to take out even more money, when she reaches age 72, she's going in and starting to take some of that money now, to satisfy her current living expenses.

Again, she could take it from her cash account, but by doing that, and delaying on the IRA, it's going to be even more money she's going to be required to have to take out, which is going to affect her taxation on her Social Security.

Because, keep in mind, your Social Security in and of itself, won't be taxable. But if you're taking out money from various income sources, such as an IRA, that can make your Social Security benefits taxable. So, and the more you take out, the higher your Social Security benefits could be taxable.

Bottom line is, she wants to take out money now. We're taking out some money now, helping to spread out those taxes. And on top of that, one of the things that we're looking at doing is taking out even more money from the IRA, so that she could do some Roth conversions.

So, moving that money over to a Roth IRA, paying the tax on the conversion, and then letting that money continue to grow tax-free into the future. And there are no required minimum distributions on a Roth IRA. So we're looking at doing that.

That could be one solution, to help leave that money behind to her kids, save money in there, and invest it, and let that money continue to grow. One of the ideas that we looked at, and this is oftentimes overlooked, is using a life insurance policy.

Most often, I find, and most often, life insurance is bought, is a way to protect...What we call family protection or income protection. Most often, people think of life insurance as primarily needed for young families. You've got maybe young kids, and/or a spouse that maybe is now, not working outside the household, is maybe staying home, taking care of the kids or whatever.

And you want to make sure that you get life insurance on that primary breadwinner. So that's income protection. And that's, again, one of the more primary uses of life insurance.

There are other uses for it, and that's what we were looking at here. So remember, she wants to give exactly $300,000 to her kids, primarily. In part of our discussions, and like I said to her, I said, "So if you knew you would have 300,000 available for your kids, when you did pass away, would you have any guilt about spending the rest of it?" And she said, "No, absolutely not. I earned it. This is, that's kind of how I would ideally want that to be split."

Here's what we looked at. Oh, and by the way, let me say one other thing, before I do that. Keep in mind that another part of the reason to taking the money from, or withdrawing money from the IRAs, doing the Roth conversions and such is, remember, her three sons are all fairly well to do. They're all making a pretty good income.

So if she were to pass away, especially if she were to pass away early, and she's got a good amount of money in the IRAs, now her kids would then have to start taking withdrawals from the IRA when they received that money. And they can no longer stretch that money out over the course of their lifetime.

Used to be, you could do a, what we called the stretch IRA. Your kids could withdraw money, just a little bit each year from the IRA, over the course of their lifetime, which was good for two reasons.

Number one, you only needed to take out a little bit. Chances are, there wasn't a whole lot of taxes that you had to, additional taxes that you had to pay. Perhaps that didn't push you into a new tax bracket and such.

But the other thing was, is that money could continue to grow and compound for the future. Now the rules have changed. Now you have to, a child must take that money out within 10 years. Now they don't need to take it all out. They don't need to space it out over 10 years. It doesn't matter. They just need to make sure that money is out within a 10-year period. That's the key.

But her kids, being in a fairly high tax bracket, making good money in their situation, they also had to start taking the income from the IRA. That means even more taxes they have to pay on the IRA, and could perhaps increase their overall tax bracket.

I mean, although certainly, they won't turn the money down. I'm sure there could be more efficient ways to pass that money down to the next generation, to her kids, and such. So the Roth IRA's certainly one way to do that. She pays the tax now, the kids won't have to worry about that tax.

Another way could be with life insurance. So let me show you that solution here again now, with no further ado. I'll share my screen.

Okay. This happens to be with Protective Life, and we're actually pricing out several different companies, but I thought I would share this one with you on here.

So we've got a sample woman. I just made her date of birth, 10/1/55. Again, she's 50, or I'm sorry, she's 65 years old. And we're looking at $300,000 of coverage.

Now this type of life insurance policy is what's called a guaranteed universal life policy. So it's a type of permanent policy, but it's like a term policy. And here's what I mean by that.

It's not a term. Let me be very clear. It is a permanent policy. It is a guaranteed universal life policy. But if you're familiar with term life insurance, if you buy, let's say, a 20-year term policy, the premium, and it's a level term policy, your premium that you're paying is going to stay exactly the same for 20 years. It does not change. 30-year, same thing. A 30-year level term, your premium stays exactly the same, let's say, for 30 years.

What this is, is this is like a term policy, in the sense that the premium is guaranteed to stay the same. The death benefit will stay the same. That's why they call it guaranteed universal life. But instead of it expiring, let's say, in 20 years or what have you, this policy will continue, really, for no matter how long she lives.

We could have had this shown until, guaranteed until she's 120, but we just kept it off at 110 here, because we don't feel that she's going to live past 110. She certainly didn't feel that she lived past a hundred, but we had to run the 110, just in case. So it's not a term policy, but it will last, she's 65 now, until she's 110.

That's 45 years. So as long as, in her case, she pays $6,101.07 per year. She will have a $300,000 death benefit, which is income tax-free, by the way, that would pay out to her beneficiaries, her three kids, $100,000 each, whenever she passes away. Okay?

Now what's interesting about this is that there's a couple of different ways she could go. She could take the withdrawals from the IRA, and we could do the Roth conversions, okay, as I already talked about, or she could take that those same withdrawals from the IRA, again, pay the taxes that are associated with that, and then pay a policy premium, as it's called here, in life insurance, to the insurance company, in this case, for 6,101.07, each year. Again, when she passes away, the $300,000 will go to her beneficiaries.

Now understand that there's a lot of different types of life insurance policies out there. You might have heard of whole life, even universal life, that has cash values, and such, and there's nothing inherently good or bad about those. They're all designed to do something a little bit different.

Just a universal life, for instance, without the actual guaranteed death benefit is going to have the risk of, perhaps, the interest rates in the policies not performing, or the company experiences higher mortality or expense costs. Then all of a sudden, you have to pay more in premium in order to keep the policy in place. All those things could happen in that.

But understand, again, this is a guaranteed universal life. That's why here, this says, Guaranteed Assumptions. And I like guaranteed with this type of scenario, because it takes all the risk away from you, and puts all the risk, if you will, on the insurance company. Again, as long as you pay the premium, the insurance company pays a death benefit. You die, it pays. That's as simple as I can describe it.

Now, this next part's going to sound weird, because this is life insurance. And if we're using this as a way to pass money along to her kids, strictly financially speaking, where this works out, the best for her, is if she passed away soon. Right?

If we look at what's called the IRR on the death benefit, so some of you might be familiar with that, others may not, but that's Internal Rate of Return on the death benefit. In other words, if she paid one policy premium, 6,101.07, and then passed away, that her kids are going to receive $300,000.

The equivalent, in other words, she would have had to earn this 4,817.17% rate of return on that money in order to equal that $300,000, all in one year. That would be an incredible investment, right?

But the chances are, she's not going to pass away right away. More than likely, she'll pass away in her eighties or nineties, or something like that, more of a normal mortality age. So let's say, for instance, she passes away when she's 85 years old, 20 years down the road.

She would have continued to pay this premium for 20 years, and her kids would get $300,000. Now the internal rate of return on that money is 7.96%. So I'm going to call that 8%. Okay? What that means is that she would have had to make 8% in an alternative investment.

In other words, if she would have to put in $6,101.07 each year, and make 8% per year on that money, and over 20 years, she would have equal the same 300, I'm sorry, down here, the same $300,000. Okay?

Now, you'll see that over time, the internal rate of return is going to decline, but if she passed away, when she was 85 years old, getting about an 8% internal rate of return, I would say, is quite good.

Now everyone's going to have a different opinion. If you think you can get nine or 10%, you may not think that that's a good rate of return, for instance, but that's a guaranteed tax-free rate of return. So, tax-free, no fees, no costs, nothing else. What you see is what you get.

Now, let's say she lives till 90. The internal rate of return would have been 4.87%, so almost 5%, but guaranteed at that time. If she lives till 95, it would have been a 3.02% rate of return. And if she lives to be 100, it would be a 1.81%. So certainly the longer you live, the lower the internal rate of return, and the worse the life insurance looks as a solution to transfer this wealth to her kids.

So, her options, and there's others, but two of them are, one, she could do this life insurance, put this 6,101 into here.

Option two is, she could fund, she could do a conversion on her IRA. And then she could end up funding the Roth IRA, doing enough so that she has $6,101. In other words, converting $6,101, and then she would pay the tax from her money that's just sitting over there in savings, and just allowing that to grow.

Strictly, financially speaking, if she passed away early, the life insurance would have been the better financial tool to pass that money along. If she passes away late, and her Roth IRA or investments perform well, then chances are, the Roth IRA would have been the better solution.

So one thing, and this is actually what she's debating right now is, she's considering doing half into the life insurance, and then half into the Roth IRA, which is a way to kind of hedge your bet, so to speak, because obviously none of us know how long we're going to live. So this can just be one extra tool in the toolkit.

I hope this is helpful. I hope it all made sense. If you have questions on it, please do let me know. And I look forward to talking to you soon, take care.


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Ryan@CravitzFinancial.com

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