In the ever-evolving financial landscape, individuals must proactively understand and optimize their financial assets. Two significant pieces of legislation—the Tax Cuts and Jobs Act (TCJA) of 2017 and the SECURE Act—have implications that will impact many retirement savings strategies, especially for those with substantial Individual Retirement Accounts (IRAs). In this article, we’ll examine these implications and offer strategies to preserve and enhance your legacy tax-efficiently.
The Sunset of TCJA Provisions
First and foremost, it’s essential to note that the provisions of the TCJA are set to sunset on January 1, 2026. What does this mean for you? The current tax rates we enjoy due to the TCJA will revert to the pre-2017 levels. For many, this could mean higher tax rates on IRA distributions.
Understanding Inherited IRAs: Then vs. Now
Before the introduction of the SECURE Act, beneficiaries of inherited IRAs had a significant tax advantage. They could “stretch” out their withdrawals and the accompanying taxes over their lifetimes. This “stretch IRA” strategy was particularly beneficial for younger beneficiaries who, by taking only Required Minimum Distributions (RMDs), could allow the majority of the IRA assets to continue growing tax-deferred for decades.
Let’s put this in perspective with an example:
Imagine Jane inherits an IRA from her grandmother at age 30. Under the previous rules, Jane could take small distributions over her expected life expectancy, potentially 50 years or more. This would not only spread the tax liability but also allow the majority of the assets to grow untouched for many years.
However, with the passing of the SECURE Act, this has changed. Most beneficiaries now must entirely spend down their inherited IRAs within ten years. This change accelerates the tax liability and could push beneficiaries into higher tax brackets, especially if these withdrawals coincide with their peak earning years.
Considering the looming sunset of the TCJA provisions, this could mean even higher taxes on these withdrawals after 2026.
A Proactive Approach: Spend Down & Insure
One strategy gaining traction, particularly among older clients with sizeable IRAs, is to start spending down the IRA before the anticipated tax rate hikes in 2026. But instead of merely withdrawing and reinvesting the money elsewhere, the funds can be channeled towards premiums for a life insurance policy.
Why does this make sense? Life insurance can serve a dual purpose for those over the age of 59 ½, who can avoid the 10% early withdrawal penalty. Firstly, the death benefit from such a policy is typically income-tax-free for beneficiaries. Secondly, it provides a known, fixed use, in contrast to the fluctuating value of investment accounts.
For instance, *consider Robert, who’s 62 and holds a sizable IRA. If he starts withdrawing a portion of his IRA now, he can use those funds to pay the premiums on a life insurance policy. Upon his passing, his beneficiaries would receive the policy’s death benefit, free of income tax. This approach shields the funds from future tax rate uncertainties and offers a fixed legacy for his heirs.*
Protecting the Legacy
Parents or grandparents can place the life insurance inside a trust to further protect this legacy. The trust can have explicit distribution instructions, ensuring that the death benefit is aligned with their wishes for education, starting a business, or any other specific purpose.
In conclusion, as the financial landscape shifts with tax laws and legislation changes, proactive planning becomes ever more essential. Leveraging strategies like spending down IRAs to fund life insurance premiums can offer a tax-efficient legacy, ensuring that your hard-earned assets are preserved and passed on optimally. As always, working closely with a financial advisor to tailor these strategies to individual needs and circumstances is essential.
