ROTH IRA v. Life Insurance

Is Life Insurance a better choice than a ROTH IRA? If you are contemplating a self-directed ROTH IRA, here is another option for consideration. While I help people with self-directed IRAs all over the country, on this concept I only work with people in WA State. I can help with a referral to other parts of the country if you are interested.

#1 – Life Insurance can be created outside of your estate

Thanks to the current $5.34 million federal exemption amount – the amount that can pass estate tax free to beneficiaries – estate tax concerns are nowhere near what they used to be and the overwhelming majority of Americans will not owe any federal estate tax when they die. Still, though, there’s a small segment of the population concerned with whether their estate will owe taxes based on the size of the estate. Many states impose state estate taxes, often with exemption amounts much lower than the one available at the federal level. In such cases, life insurance may offer an advantage over Roth IRAs.

The “I” in IRA stands for individual, meaning it’s always yours and therefore, the value of your Roth IRA is always included in your estate. If you’re above the federal estate tax exemption amount or your applicable state estate tax exemption amount, your beneficiaries could end up owing estate tax – at the federal level, state level, or both – on what you thought were “tax-free” Roth IRA assets.

Life Insurance Trust
Life Insurance Trust

Life insurance, in contrast, can be structured so that it’s outside of your estate, producing not only an income tax-free benefit to your heirs, but also one that is not subject to estate tax, regardless of the value of your estate when you die. In other words, a truly tax-free benefit. There are a variety of ways to accomplish this, including having an irrevocable trust purchase the life insurance policy or, perhaps, your children or other interested parties. In WA State, I can help set up these trusts and the life insurance owned by the trust. See my Life Insurance Trust post here.

#2 – Life insurance higher contribution limits

Insurance carriers may limit the amount of insurance they will offer you based on a variety of factors, including your health, annual income and your net worth. The tax code does not restrict how much life insurance you can own. In contrast, if you want to make annual Roth IRA contributions, you’re fairly restricted. For 2017, you can contribute no more than $5,500 ($6,500 if age 50 or older by the end of the year) to a Roth IRA. You can also convert any existing IRA or eligible retirement plan funds to a Roth IRA, but that assumes you have them already.

In addition, there’s no rule on what type of income you need to have in order to purchase life insurance. Roth IRA contributions, on the other hand, do have such restrictions. Roth IRA contributions, for instance, can only be made with income that qualifies as “compensation,” which is typically earned income. In contrast, life insurance premiums can be paid with any type of income, including interest, dividends and Social Security, all of which are not considered compensation. For that matter, if you had no income, you could simply pay for life insurance premiums from your existing assets.

There are issues on the other side of the spectrum too. If you have too much income, from whatever sources, you are prohibited from making any Roth IRA contribution. The IRS web page with the 2017 limits is available here. With life insurance, there’s no limit to the amount of income you can have. In fact, all things being equal, you can generally qualify for more life insurance with a higher income.

#3 – No RMDs for Life Insurance

When you leave a Roth IRA to non-spouse beneficiaries, such as children, they must generally begin taking RMDs (required minimum distributions) from the inherited Roth IRA no later than the year after they inherit. These distributions are usually tax-free, but they must be taken nonetheless. When beneficiaries inherit life insurance, there are no RMDs to worry about. Here’s something to consider, however. While not having to deal with RMDs is nice, that mere fact doesn’t necessarily make life insurance a better option for your planning than a Roth IRA.

Consider the following: when a beneficiary inherits life insurance, the only amount they’ll receive tax-free is the actual life insurance proceeds. If they don’t need the money right away, they might invest the proceeds. Whatever interest, dividends, capital gains or other income those investments generate will be taxable, unless, of course, they are invested in assets that don’t produce taxable income, such as municipal bonds. In contrast, while the inherited Roth IRA will have RMDs to deal with, those amounts may be relatively minimal.

Take someone who inherited a Roth IRA at age 50, for example. In such a case, RMDs would start out at roughly 3% of the account value. The rest of the Roth IRA, however, can be left alone to grow, and that growth can later be distributed tax free as well. So, whereas a beneficiary of a $500,000 life insurance policy will only receive $500,000 income tax free, a beneficiary inheriting a $500,000 Roth IRA may receive many times that amount in tax-free distributions over the course of their lifetime, particularly if they stick to taking only the RMD each year and no more.

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