Fixing the Qualified Plan Wealth Transfer Problem

October 11, 2021

Tax Bill

What's the problem?

Many believe that qualified plans and annuities are efficient savings vehicles for retirement. For many Americans this is true. However, for clients that have personal financial security and taxable estates, these vehicles become some of the most inefficient ways to transfer wealth.

Major concerns include:

  • The growth in these vehicles is income taxable upon withdrawal and stretch options are no longer available.
  • These vehicles cannot be moved outside of one's taxable estate meaning the value will be subject to tax.
  • Income may be forced out of the investment through an RMD or an annuity when it is not needed.
  • And the list goes on... 

In fact, the situation is so dire the IRA Guru, Ed Slott, has said, "So now the IRA is not a valuable asset. It's like an old jalopy that is pooped out at death. So you got to get rid of that." Wow!

3 Smart Alternative Strategies

#1 Convert to Life Insurance

This strategy involves draining the qualified account during life to pay insurance premiums and effectively replacing this asset wholly with life insurance. 

Success Story:

For Jim H's client we decided to convert a taxable $4M annuity into a guaranteed income stream for life. This can be accomplished by annuitizing with the existing insurance company or exchanging the annuity for a Single Premium Immediate Annuity (SPIA). In return for giving up the full principal amount at death, a SPIA guarantees an income stream for life. 

Jim is this client's investment advisor and was worried about the poor performance of the indexed annuity - not to mention the fact that it would be income taxable and estate taxable at her death. He asked TDC Life for a recommendation here is what we did:

  • Converted $4M of annuity cash value into an $204K after-tax lifetime income stream.
  • Used the above annual income to buy a $6M life insurance policy. This ensured that, in the event of a sudden death, the client's family would be $4M ahead on after income and estate taxes.
  • The life insurance policy had a feature called Return of Premium which means that every time a premium is paid the premium amount gets added to the death benefit.
  • So, at the client's life expectancy the death benefit grows to over $10M tax free. If she dies at her life expectancy her family will receive just under $5M more benefit than the net after tax annuity amount. 

#2 Donate and Replace with Life Insurance

By adding charity to the mix we can further reduce the amount the IRS gets and add-in benefits for a charitable cause the client cares about.

Success Story:

An educational institution reached out to our sister firm, Legacy Giving, for advice regarding a husband and wife donor that had a $5M IRA. They did not need the income from this plan to support their personal financial security.

Before talking to our team, they planned take the Required Minimal Distributions (RMD) from the IRA, invest those funds and ultimately leave the IRA and the investment account to their kids.

Legacy Giving suggested that, by adding a charitable component to their planning, they could do some good for their alma mater and INCREASE what is available to their children. The only one losing in this plan was the IRS. 

Here was the plan:

  1. They will use qualified charitable distributions (QCDs) to reduce their RMD.
  2. The remaining RMDs are used to fund life insurance coverage to benefit the children inside of an irrevocable trust. 
  3. The remaining IRA balance will be donated to the university at death.
  4. The kids receive tax free death benefit protected inside a trust. 

This strategy resulted in $0 going to estate taxes, $5.7M going to the educational institution and $8.48M going to the children. $3M more than their original plan. 

Check out this quick video to learn more about this strategy:


IRA and Charity, the perfect combination.

When used together, life insurance and IRAs could mean passing tax-free dollars to the next generation.


#3 Purchase Life Insurance in a Profit Sharing Plan

Some profit sharing plans allow participants to purchase life insurance within the plan. For others this option can be added with a simple plan amendment. Typically we would not recommend this strategy, but for clients who will not need to access the profit sharing plan dollars during life, converting these dollars to tax-free life insurance may be a smart play. There are a number of rules and regulations to keep in mind when employing this strategy so please make sure you are working with an expert in this area if considering this idea.

Success Story:

A long-time client owned a business and had built up a significant profit sharing plan balance of $2.3M. Assuming he died, this value would, after income and estate tax, net his kids about $800K. He was single and had a significant taxable estate. He wanted to make sure his 3 daughters each got $2M each even if he spent all of his money during his lifetime.

Here is what he did:

  • Purchased a $6M life insurance policy in the profit sharing plan with and upfront premium of $1M. 
  • After holding the policy in the plan for a few years, his irrevocable trust bought the policy out of the plan for the PERC value of the policy about $600K.
  • This resulted in his trust having a $6M tax free life insurance policy and reducing the plan value by $400K.

The Bottom Line:

For your most significant clients savings built up in qualified plans and/or annuities are in tax jail, income and estate taxes could come into play when transferring these dollars to their kids. Acting early and being creative with planning can mean significantly more generational wealth. We here at TDC are expert on these strategies and many more. We look forward to discuss a real life client situation and bring great ideas to benefit them.