Why You Should Consider Leaving Your Heirs Life Insurance or Annuities (Instead of Your Qualified Plan Money)
If you’ve been thinking about creating a legacy for your loved ones, you may believe that leaving them money from your IRA or 401(k) is the best option. You may have also looked into trusts as a way to ensure that your loved ones are taken care of after you pass. While both of these tools can be useful in legacy planning, two other financial vehicles may be a better fit, especially if you are concerned about taxes.
Life insurance and annuity products, while providing numerous benefits for you while you are alive, can also help you create a tax-advantaged inheritance for your heirs.
IRA and 401(k) Tax Traps
The main concern in leaving a 401 (k) or IRA to your heirs is almost always taxes. In the past, a “stretch IRA” strategy allowed people to draw out the life and tax advantages of a traditional IRA. Stretching an IRA gave the funds in it more time to grow tax-deferred.
Unfortunately, the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act at the end of 2019, put an end to stretch IRAs starting in January 2020.
Under SECURE, beneficiaries must take out all of the money in 401 (k) plans and IRAs within ten years. This means that if a person inherits an IRA through a trust, he or she must take out the entire amount and have no chance to take distributions during the 10-year-wait.
Payouts are taxed as regular income at the beneficiary’s income tax bracket. Thus, beneficiaries are subject to substantial tax bills, which could result in a loss of 50% or more of their legacies!
How Life Insurance Can Help
Life insurance may provide a tax-advantaged alternative to passing on your 401(k) or IRA. Proceeds from a life insurance policy are, in general, not included in your gross income at tax time. Such tax treatment could be a real benefit to your loved ones.
You may want to use life insurance to leave a legacy if:
- You don’t want your heirs to pay more in taxes than necessary.
- Some of your assets are hard to divide, like real estate or farmland.
- You want to leave specific dollars amounts to your heirs.
- You own a business.
- You care for someone with special needs and want them to continue to be well-cared-for
- You want to provide additional money to your beneficiary to help with expenses. These could be costs associated with maintenance, insurance, and other operating expenses of a business or property you have left to them.
- You would like to create liquid funds to help transition your business when you die.
- You want your beneficiaries to be paid directly and not have to wait for probate.
An Overlooked Alternative
Annuities are another, often-overlooked, alternative to leaving a legacy. While annuities may not offer the same tax advantages as life insurance, they do have special qualities that could make them attractive to some people. An income annuity is the only way to leave a contractually guaranteed lifetime income to a loved one.
For example, you could buy a deferred income annuity, also known as a longevity annuity for a child or grandchild. You make a lump sum deposit into that annuity. Then, you choose the age at which you want your child to begin receiving payments. Those payments will continue for the rest of his or her life on a monthly or annual basis.
There is also the possibility of using an annuity to extend your legacy to your great-grandchildren. Continuing your legacy in this manner requires a particular kind of annuity, along with specialized planning.
Some annuities will allow you to add inflation-protection riders to help your legacy recipients retain their future purchasing power.
Whatever financial vehicle you choose to create your legacy, you need to consult your financial advisor. He or she will direct to the product that is best suited for your particular situation and goals.
Be sure that the advisor you choose is experienced in legacy creation and can provide you with a list of pros and cons for each product you are considering.