IRA planning

We recently worked with a client that had the following challenge: while they were both alive, their annual income tax liability was pretty low, less than $1,500. But upon either one of them dying, the annual income tax liability for the surviving spouse was projected to skyrocket to over $7,500, more than a $6,000 increase!

Why is this the case?

It is because a decent portion of their income comes from their IRAs. While they are both alive, they file tax returns as “married, filing jointly”. These tax brackets are some of the most lenient in the entire tax code.

But, when one of the dies, the surviving spouse files taxes as a “single” taxpayer. These are some of the harshest brackets in the tax code.

And like a lot of people, the clients we are talking about had a large percentage of their assets in retirement plans. IRAs and other retirement plans like 401ks, 403bs, etc. can cause significant tax challenges for surviving spouses, as we see in our little example.

Now you need to brace yourself. The story above is not uncommon. In fact, it is actually a very common issue, and it may very well apply to you.

So what should you do about it? That is the $64,000 question.

First, you need to find out what your tax return would look like for your surviving spouse (or you, if you are the survivor). This analysis will tell you if you have a potential problem.

If you do, then here is a really simple idea that you may want to consider. WARNING: it is an idea that would normally not be on your list of options.

Are you ready?

Why not distribute some extra income out of your IRA (or other retirement plan) today, and each year thereafter, while you and your spouse are both alive and enjoying those lenient tax brackets? Yes, you will owe additional tax on those distributions, but here is the important part – that additional tax does NOT affect your current lifestyle.

Then, what if you took that after-tax amount of the distribution each year and used it to fund a life insurance policy on both your life and the life of your spouse?

I bet you weren’t expecting that one!

Life insurance? At your age? Wouldn’t that be expensive?

Surprisingly, due to increasing life expectancies, life insurance pricing has dropped considerably. As a result, planning like this becomes very effective.

The nice thing is that when the first spouse passes away, the surviving spouse receives a nice big tax-free check from the life insurance company. They can use that check to do a number of things:

• They might convert the IRAs to Roth and pay the tax from the life insurance proceeds. Then all income from the IRAs would be 100% tax-free.
• They might pull some additional income from the life insurance proceeds, again positively managing their tax return.
• If the life insurance policy is large enough, they might go ahead and give the tax toxic IRA money to the kids, and live off of the life insurance proceeds.

As you can see, adding a large tax-free check to the list of assets that a surviving spouse has to work with can make a huge difference for them. And remember, for the surviving spouse, any additional income tax DOES affect their lifestyle.

So why not consider paying some extra tax today when it does NOT affect you so that your surviving spouse (or you!) can avoid taxes later when they DO affect you?

If you would like to discuss IRA planning in more detail, please give me a call at 215-968-1755 or contact me by filling out the contact form on this site and I will get back to you.