Are You Financially Ready for Retirement? Plan Ahead

The assets in your qualified and non-qualified retirement plans will be included in your gross estate when you die. For those who have accumulated substantial assets in their retirement plans, the inclusion of these assets in their estates may cause a tax problem. So, you may have to pay a tax for which you had not planned.

Many estate planners recommend that people use life insurance as a means to provide liquidity to their heirs for the payment of any future federal gift and estate tax resulting from the inclusion of retirement plan assets in your estate. In most cases, estate planners recommend that you set up an irrevocable life insurance trust and name your heirs as the beneficiaries of the trust. You can then either transfer an existing life insurance policy into the trust or make gifts of cash into the trust so that the trustee can buy a new life insurance policy on your life. If you do not retain any incidents of ownership in the policy within three years of your death, the insurance proceeds should not be included in your gross estate.

Another possible option if your spouse is still alive is to purchase a second-to-die life insurance policy. Then, when the surviving spouse dies, your heirs can use the insurance proceeds to help pay the applicable tax due at that time. Your heirs will then have the necessary cash to pay for any increase in your tax because of the inclusion of the retirement assets. (One exception to this rule is if you transfer an existing insurance policy to another individual or into a trust, and then you die within three years of the transfer. The insurance proceeds will then be included in your gross estate, but the proceeds will still be available to pay any associated taxes.)

You may want to consider using life insurance to provide liquidity to your heirs (to pay the federal gift and estate tax on your retirement plan assets) even if you plan to leave all your assets to your spouse. Although transfers to a spouse qualify for the unlimited marital deduction (meaning an unlimited amount of assets can be left to your spouse without paying any tax), when your spouse dies, then the assets will be subject to tax. Your heirs (usually your children) will then be responsible for paying the applicable tax. To provide liquidity to their heirs at this point, many people will purchase a second-to-die life insurance policy (so that when the surviving spouse dies, the insurance policy will pay off at that point). It is important that the ownership of this policy be set up properly, so that the insurance proceeds are not included in the surviving spouse’s estate. Another benefit to using a second-to-die life insurance policy is that the premiums on these policies are usually less than the premiums for an insurance policy on a single life.

Of course, there are some drawbacks.  Depending on your age and health, purchasing a large cash value life insurance policy on your life can be very expensive. In addition, the cost of setting up and maintaining an irrevocable life insurance trust can also be high. You will need to hire an experienced, competent estate planning attorney to draft the trust documents. If you hire a professional trustee (a bank trust department, for example), you may have to pay an annual trustee’s fee. You may also have to hire an accountant to file trust tax returns.