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Monday, May 6, 2024
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Case Studies |
A Tax-Favored Gift of an IRA
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Case:
Arnold and Rebecca Conrad, both age 62, retired at the age of 55 and have been traveling extensively over the past several years. They support a number of missionary organizations and, in their travels, have visited a number of missionaries throughout the world. They have been to such places as Africa, the Middle East, Russia and a number of countries in Central and South America. Arnold and Rebecca have two children, both of whom have chosen to be career missionaries. The children are married, and both couples have three children.
Because of the love Arnold and Rebecca have for mission causes, they would like to leave most of their estate of $25 million to the causes they have supported throughout their lifetimes. However, because their children have chosen to be missionaries, Arnold and Rebecca are concerned that the children will not have adequate funds to retire when that time comes. Arnold has a large IRA account currently valued at $12 million. In a recent meeting with their attorney, they were told that if they transferred the IRA to the children upon their passing, the IRA would be eroded by approximately 70% due to income and estate taxes. Therefore, if Arnold and Rebecca died today, the children would receive only about $3,600,000 of the $12 million in IRA assets. Arnold was appalled by this result, as he had done well to invest the IRA assets wisely over the years and was not pleased that the government would step in and take 70% of the IRA in taxes. They love this country, but they have paid their fair share of taxes throughout their lifetimes and paying such onerous taxes on the IRA account was not in their plans.
Question:
The attorney explained to Arnold and Rebecca that retirement plans were set up by the government to be just that: retirement plans, not inheritance plans. He further stated that they could not fully avoid the tax bite if they wanted the IRA to pass to the children when they are gone. After hearing the bad news, Arnold stated that he had recently attended an estate planning seminar sponsored by one of the missionary causes. At the seminar, the speaker discussed the idea of using IRA assets to fund a testamentary charitable remainder unitrust. Arnold asked the attorney whether or not this would work in their situation or if there were any other methods to transfer the $12 million to the children with little or no transfer tax.
Solution:
The attorney stated that Arnold and Rebecca could use the IRA to fund a testamentary charitable remainder unitrust with distributions to their children for their lives. However, since their children are ages 42 and 38, the $12 million used to fund the trust would produce a charitable estate tax deduction of approximately $1,283,000, based on a 5% payout rate. Therefore, the children's income interest in this trust is still worth over $10.7 million ($12,000,000 less $1,283,000 charitable deduction) and their estate may still be subject to estate tax and income tax on the trust payments. After seeing the estate and income tax consequences of such an arrangement, Rebecca asked the attorney if there would be a better way to transfer the IRA to family and ultimately to their favorite mission causes. The attorney stated that one alternative that came to mind might be ideal for them.
The attorney went on to suggest that they consider establishing an irrevocable life insurance trust (ILIT) utilizing a second-to-die policy on the lives of Arnold and Rebecca. The ILIT would purchase a $12 million life insurance policy on both their lives, which would be funded with withdrawals from the IRA. The attorney had discussed the cost of the insurance with his friend who is a CLU and was informed that the cost of a policy would be in the range of $50,000 - $60,000 per year. Based on conservative interest assumptions, the policy would be paid up in about 25 years. Arnold and Rebecca would gift the premium dollars to the ILIT each year using "Crummey" powers, which would make the payments subject to the annual gift exclusions. Upon their passing, the insurance proceeds of $12 million would fund the ILIT. The beneficiaries of the ILIT would be the children who would receive distributions from the trust completely free of any estate taxes. Also, any principal received from the ILIT would be free of any income taxes. The results: instead of paying estate taxes, Arnold and Rebecca pass the $12,000,000 to the children with absolutely no estate tax.
In regard to the IRA, Rebecca is currently designated as the primary beneficiary. The contingent beneficiary(ies) will be changed to their favorite mission causes. Therefore, whenever the survivor passes away, the remaining IRA assets will pass to charity, once again, free of estate taxes and also free of income taxes. In this way Arnold and Rebecca are able to make a substantial gift to both their children and to charity without any dilution due to taxation. Also, they still have their exemptions to use to pass additional assets to their children should they so desire.
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