Permanent Life Insurance: IRA ‘Arbitrage’

Rising taxes and elimination of stretch IRAs have me rethinking legacy planning for my family and clients.

By Brent R. Anderson
Brent Anderson
Brent Anderson

Taxes are going up. As an advisor and aging baby boomer receiving Social Security and Medicare, I recognize it is political suicide for any politician to suggest reducing those entitlements. With the national debt now over $33 trillion, and with interest rates higher, it takes much more capital just to pay the debt service, much less repay the debt.

Where does the money for entitlements, debt-reduction, and debt interest payments come from? It comes from taxes, and it is a well-known fact that our government spends more than it brings in. The government can either reduce expenses or increase taxes, and it seems that neither party is any good at reducing expenses. So, taxes are going to have to go up.

Who is going to pay those increased taxes? Hopefully, I will live long enough to feel that effect, but the real burden falls on the generations that came after mine, and that means it will be our children who will be paying higher taxes.

The top federal tax bracket today is 37% and is already slated to go back to 39.6% in 2026 with the sunset provision in the Tax Cuts and Jobs Act of 2017. In my baby boomer lifetime, I have seen top brackets at 70%, so I know, historically, there is a great precedent for higher taxes.

A change in thinking

All my career, the basic rule of “Tax Planning 101” has been to defer taxation as long as possible. Common advice from financial advisors and CPAs was to max fund the 401(k) and IRA and take as little as possible from the qualified plan when you reach RMD age. The thinking was that tax brackets will be lower in retirement, so defer now and pay taxes later.

Well, times have changed, and new economic realities are forcing us to rethink our strategies. Noted tax expert, Ed Slott, in his recent Investment News article advised people to stop contributing to their IRAs and 401(k)s and look to more creative solutions.

In “the good old days” (pre-2020), we had the inherited stretch IRA that allowed our non-spouse beneficiaries the right to continue to defer taxation for their lifetime, only withdrawing a minimal required minimum distribution (RMD) based on the age of the decedent. Today, because of SECURE Act 1.0 (which eliminated the stretch IRA) and SECURE 2.0 (which added clarification), those non-spouse beneficiaries must withdraw the entire balance within 10 years. And if you left a substantial IRA, the required RMD alone may push those beneficiaries (who quite likely will be in their own peak earning years), into a higher tax bracket.

Look at the graphic below to see the detrimental effect that eliminating the stretch IRA will have on our children.

Suggestions for boomers

Rather than defer taxation to a time of potentially greater taxation, I’ve been telling my clients to consider:

  • Reducing those qualified plan balances, and paying the taxes today, and leaving more tax-favored assets to their heirs.
  • Doing Roth conversions. A properly-converted Roth can still accumulate tax free but will pass to heirs, income-tax-free for their lifetime. Converting to a Roth requires payment of the taxes owed. As previously mentioned, perhaps these are the lowest tax rates we’ll see for a very long time.
  • Taking after-tax money and buying assets such as stocks, bonds, mutual funds and real estate. That may require clients to pay a little tax during their lifetime but their heirs will get a step-up in basis at the owner’s death. Yes, there is some investment risk, but the eventual tax savings may well offset the risk.
  • Buying permanent life insurance. I have found this to be one of the most efficient and creative uses of after-tax money, and will discuss it more in a bit.

I confess that it’s not “easy” to offer these strategies, as really, I’m suggesting some new thinking.  I’m not telling 30-year-olds not to max their 401(k), but I am suggesting that to my aging clients and boomer friends.

Like myself.

I normally would be putting aside $50,000+ into a simplified employee pension plan (SEP) this year but, taking my own medicine, I will not because I’m just deferring taxes to a later, unknown bracket, and creating a tax-time-bomb asset that is not good for me to leave for my kids.

A toolbox favorite

Permanent life insurance is one of the most tax-advantaged and flexible instruments in our financial toolbox. Life insurance cash values grow tax-sheltered, and the death proceeds are received income tax-free, probate-free, and if properly structured, possibly also estate tax-free.

As the value of an IRA is reduced by the payment of the taxes and insurance premiums, it is replaced by life insurance, which will eventually pass to the heirs, income tax free and with unlimited flexibility of use. It’s an arbitrage that I find works well.

Assuming insurability, look into the costs of a single life policy, or perhaps a second-to-die policy, which bases the premiums upon the life expectancy of the youngest, and often the healthiest, of two insured lives. Premiums can be paid over the insured’s lifetime or for shorter periods such as five or 10 years.

A legacy for my own children

I’ve done this myself, and it’s been so powerful for my estate plan. The relatively modest premium funds a sizable second-to-die policy. My wife now feels more comfortable spending our retirement assets on vacations, gifts and home improvements, because she knows at the survivor’s eventual death, there will still be a substantial legacy asset for our four children.

Annual exclusion gifting to children has long been popular but rather than unrestricted giving (think Las Vegas, boats, and Corvettes), clients can gift after-tax dollars to children to purchase accumulation-oriented, permanent life insurance. This can substantially leverage the gift’s value.

Properly designed, an accumulation-oriented policy, often called a LIRP (life insurance retirement plan), acts like a super-charged Roth IRA. Contributions are with the client’s after-tax dollars, cash values accumulate tax-sheltered and withdrawals can be made tax-free, in the form of loans secured by the policy cash values.

A word of caution

Make sure that the policy does not become over-loaned, which could cause it to lapse. However, many insurance companies have policy provisions to guard against this possibility. The loans against the policy cash values are repaid at the child’s (insured’s) eventual death and the net death benefit (after loan repayment) is income tax free.

I did this for my own children. One of them, a schoolteacher, confided in me, that knowing she will have a more secure retirement allows her to “continue doing what she loves, while not resenting the salary.” Made me a little misty-eyed, to say the least.

Looking ahead

Given all I’ve seen during more than 50 years in the industry, I reserve the right to be smarter today than yesterday. I’m always learning and open to new ideas and evolving financial planning solutions. What worked in the past is not necessarily the best route for the future. Much of my efforts today are to continue to educate my clients on this new tax arbitrage and help them be more efficient in their estate and legacy planning.

Certainly, in some cases the decision to defer today is still appropriate, and if your ultimate estate plan is to give your qualified plan balances to charity, then “defer away!” But for the comfortably-affluent, those who have more than enough, their financial future can be made more tax-efficient, and their legacy can be improved substantially, by paying some taxes today to save taxes in the future.

Brent Anderson, CLU, ChFC, CFF, is a financial advisor in Santa Barbara, Calif., and has been in the financial services business since 1970. He began his career selling risk-management solutions such as life and health insurance, disability income insurance, and encouraging people to save as much as they can into retirement plans. Brent is married with four children, 11 grandchildren and seven great-grandchildren. He also sings in a barbershop quartet.

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