A Good Problem to Have
Steve is a retired Surgeon. He has managed to accumulate more than enough assets over the course of his working years to support he and his family's lifestyle quite comfortably. His estate when he dies will fall under the $10.5 million exemption, and so estate taxes are not an issue. He also manages his current tax situation quite well.
He does, however have one issue. With two children and six grandchildren, he'd like to be able to leave most of his IRA assets to them when he dies. He simply does not need the money. The government requires him to begin taking required minimum distributions from these accounts at age 70 1/2 which will reduce the amount available to them. To make matters worse, all of his IRA money is in a variable annuity, which is one of the worst places to have money at death (but not during accumulation: see TaxAdvantaged Vehicles), due to the heavy taxation on these type accounts. Presently there is $500,000 in this annuity. After taking RMD's and taxes at his death, easily more than 50% could be drawn away before ever getting to his children. Being an ardent Trump supporter, this makes Steve sick to his stomach.
Is There a Way Out of This Dilemma?
Fortunately for Steve, there is a way to rescue his IRA money from the hands of the tax collector, and deliver it tax-free to the next generation. The solution involves using a section of the tax-code that allows a 1035 exchange between some insurance products into other insurance products, with no tax consequences. Here's how Steve will handle his problem:
Step 1: Do a 1035 Exchange from the variable annuity into a single premium immediate annuity. Do your research beforehand to determine which immediate annuity will pay you the highest amounts of monthly payments. There are no tax consequences here.
Step 2: Annuitize your new contract. Here's where you'll begin taking an income from your new annuity. This income will be part taxable, and part tax-free. I know, the whole point was that you didn't want to take RMD's, but bear with me...it all works out, I promise. By taking this step you have removed any market risk from your plan.
Step 3: Purchase a life insurance policy on yourself (this scenario assumes you are healthy enough to do that) to provide at least $500,000 in death benefit. Pay for this policy with the annuity payments. Anything left over can be mad-money. When you die, all of this will go to the beneficiaries you have selected tax-free. You have, in effect, converted a highly-taxed asset at death, into a tax-free one. You've also generated extra income for yourself while you were still living.
An Added Extra Bonus (no charge)
Let's suppose that Steve's estate was above the $10.5 million exclusion, and he'd owe estate taxes. He could, after step two above, create an Irrevocable Trust, and gift the annuity payments into the trust. Then the Trustee, having been prviously instructed, could use the money to purchase the life insurance, making the trust the owner of the policy. Then, any money gifted into the trust would be subtracted from the value of his estate, thereby lowering, or even eliminating his estate tax.
Steve should keep in mind, however, that should he ever run for President of the United States his opponent will accuse him of being the Antichrist for "not paying his fair share." That's about the only downside of using a 1035 exchange as one of your favored tax strategies.
Until next time,
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