Roth IRAs and life insurance share some important characteristics. There are significant differences when it comes to estate planning, however. Let’s take a look at how they compare as estate planning tools. For the purposes of our discussion, we will compare Whole Life Insurance to a Roth IRA.
In a previous blog post we summarized the differences between Traditional and Roth IRAs. You can access this post here if you would like more information: https://highfallsadvisors.com/blog/traditional-ira-or-roth-ira.
First, let’s look at some common features of these two strategies while you are still living:
|Whole Life Insurance||Roth IRA|
|Tax deductible premiums or contributions||No||No|
|Tax deferred growth||Yes||Yes|
|Require minimum distributions||No||No|
*You can borrow from your life insurance policy which is a way to access the cash value without paying income
Due to the possibility of future tax rate increases, one of the most attractive shared features of Whole Life Insurance and Roth IRAs is tax-free access to your funds.
Let’s now turn our attention to estate and legacy planning:
|Estate and Legacy Planning||Whole Life Insurance||Roth IRA|
|Includible in your estate||Maybe||Always|
|Annual funding limitations||No||Yes|
|Require minimum distributions after your death||No||Maybe|
Includible in Your Estate
Roth IRAs will always be included in your estate since the account is individually owned. There is no way to change that without withdrawing all the funds from your Roth and putting them into a different account that is easily transferred to another person.
Life insurance proceeds are includible in your estate if you own the policy. There are several ways to change this outcome; a life insurance trust is one common technique.
Annual Funding Limitations
Roth IRAs have several limitations on how much you can contribute each year. First, you need to have earned income. If you are married and have over $204,000 of modified adjusted gross income, the amount of your contribution is reduced. A similar adjusted gross income limitation applies for other filing statuses.
The basic 2022 contribution limit is $6,000; however, the limit increases to $7,000 if you are 50 or older. You could consider a Roth conversion strategy to increase the funding of your account, although this comes with tax consequences.
Life insurance funding and the size of your policy is ultimately limited by the insurance carrier. Generally, there aren’t similar limitations imposed by tax rules on the amount of insurance you can buy. Any type of cash flow can be the funding source for life insurance, including interest, dividends, social security and pension income. There is an extensive underwriting process that you must pass in order to qualify for insurance, however.
Required Minimum Distributions (RMDs)
While there are no RMDs from a Roth IRA during your life or when your spouse inherits the account, there are RMDs for non-spousal beneficiaries. The account will eventually need to be distributed in that case, most likely to your children.
In general, your children can enjoy the continued tax-free growth and distribution of the Roth for up to 10 years. While life insurance is income tax-free to the beneficiary, there is no mechanism for tax-free growth on the proceeds. The beneficiaries will pay income tax on the dividends, interest and capital gains generated by the insurance proceeds.
If one of your goals is to pass your estate to your beneficiaries with as much tax efficiency as possible, Roth IRAs and life insurance are two strategies to consider. To find the planning solutions and strategies that are right for you, seek advice from a specialized CPA, Attorney, or CERTIFIED FINANCIAL PLANNER™ (CFP®).