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Sidestep tax whammy on retirement funds: Buy life insurance

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in Leaders & Managers,Management Training,Small Business Tax,Small Business Tax Deduction Strategies

If you die with most of your retirement funds intact, your family could get walloped by estate tax on top of a hefty income tax bill for required plan distributions.  

Strategy: Use retirement plan funds to buy life insurance. When you die, the life insurance benefits are tax-free to the beneficiaries. They can use the cash to pay off their tax bills and pocket the rest.

Retirement accounts may be shrinking, but tax shelters have grown impressively in 2009. Find out which new credits and tax breaks are intended for you... Retirement Tax Guide

Plan participants must begin taking required minimum distributions (RMDs) from an employer-sponsored retirement plan after reaching age 70½. Since the participant has to take cash out of the plan anyway, the money might as well be put to good use. (The RMD rule has been suspended for the 2009 tax year only.)

However, if an employee dies before exhausting the plan funds, the balance is distributed to his or her beneficiaries. For a nonspouse beneficiary, the funds generally are distributed over a period based on the beneficiary’s life expectancy or no more than five years. Alternatively, a nonspouse can now choose to roll over the funds to an IRA, but a nonspouse still can’t postpone RMDs.  

Distributions are taxed to the beneficiary at ordinary income tax rates. Plan funds available at death are included in the participant’s taxable estate.

This creates a double-tax whammy. First, the estate tax is applied to the plan assets, and then the beneficiaries must pay income tax on the distributions required by law.

Identify how best to shelter your retirement funds, by taking advantage of the many tax-reducing trusts, credits and deductions that apply to your situation. Retirement Tax Guide

Example: Say you have $1 million in your retirement plan that you’re leaving to your daughter, the sole beneficiary. First, the retirement plan assets are exposed to estate tax when you die. Assuming the current maximum tax rate remains at 45%, the resulting estate tax liability is $450,000.

Second, your daughter takes a lump-sum distribution of the assets that is taxed at the highest income tax rate, which is currently 35%. So she has to pay $350,000 in income tax (35% of $1 million). However, when receiving this “income in respect of a decedent” (IRD), at least your daughter is entitled to an income tax deduction for the estate tax attributable to the taxable distribution. The IRD deduction is claimed as a miscellaneous expense.

Finally, the family must also contend with applicable state and local tax laws.

Although insurance premiums may be high as you near retirement, no income tax or estate tax is due on life insurance proceeds.

Tip: The tax law limits the amount of life insurance you can buy within a retirement plan (see box).


Newly updated for 2009, The Retirement Tax Guide will show you how to:
  • Assess qualified versus non-qualified plans
  • Trim your tax bill
  • Cash in on annuities
  • Shelter your retirement income
  • Maximize your home equity
View Table of Contents


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