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June 1, 2004

Is There Still a Need for Second-to-Die Life?

Survivorship life insurance policies, also known as second-to-die life, insure two lives, with the insurance proceeds paid after the death of the second insured. This insurance is often used to provide financial liquidity to pay estate taxes after the death of the second spouse. But with the repeal of the estate tax slated for 2010, is this insurance still needed?

Until 2010, the estate tax still exists. So unless you're positive you and your spouse won't die before then, you may still have a need for this type of insurance. After that, the estate tax will be eliminated in the year 2010, only to be reinstated in 2011 based on 2001 tax laws. Further legislation is required for permanent estate tax repeal, definitely not a certainty at this time. Thus, if you currently own second-to-die life insurance, you probably wouldn't want to cancel it until these issues are resolved. Whether you need to obtain a new second-to-die insurance policy is a more difficult decision.

Besides using these policies as a means to fund estate taxes, you may find them to be appropriate in other circumstances, including:

  • Business owners wishing to leave the business to one child can use the policy proceeds to provide for children not involved in the business.

  • The proceeds can be paid to a favorite charity, so the charity receives a substantial contribution without depriving heirs of estate assets.

  • If both parents work, a second-to-die life insurance policy can ensure minor children are adequately provided for in the event both parents die.

The premium for a second-to-die life insurance policy is typically less than comparable coverage on either individual life, since only one benefit will be paid. Coverage can usually be obtained for an uninsurable person as long as the other person is insurable. If the policy is properly structured, the proceeds can avoid both income and estate taxes.

Although not suitable for everyone, survivorship life can be an attractive planning tool to meet specific needs.

Should You Rent or Own Your Home?

It seems like everyone either owns a home or is saving to purchase a home. Certainly, there are significant financial and tax reasons for owning a home. While you typically only make a down payment of 10% or 20% of the home's cost, you retain all price appreciation on the home. Part of each mortgage payment builds equity in your home. In the beginning, that may only be a small portion of each payment, but significant equity can be accumulated over a period of years. Historically, homes have provided a good hedge against the impact of inflation.

There are also significant tax advantages to home ownership. Mortgage interest and property taxes can be deducted on your tax return as itemized deductions, reducing the cost of home ownership. When you sell the home, a significant amount of capital gains can be excluded from tax. If the home was your primary residence in at least two of the preceding five years, you can exclude $250,000 of gain if you are a single taxpayer and $500,000 of gain if you are married filing a joint return.

But despite these advantages, you should still evaluate whether owning a home makes sense for your particular situation. Some factors to consider include:

  • How long will you live in the home? Besides the purchase price of the home, you must pay closing costs, which can add substantially to the cost. There are also costs involved when you sell the home, which typically include the real estate agent's commission of 6%. Thus, you'll usually need to live in the home for at least five to seven years to make it a worthwhile financial decision. If you plan to move before that, carefully calculate your costs before purchasing.

  • Can you afford to take on the debt? Generally, lenders prefer that your total debt payments, including your mortgage debt and other consumer debts, not exceed 40% of your gross income. Don't simply rely on this rule of thumb. Make sure you're comfortable with the amount of debt you are incurring and you'll still have enough disposable income to save for other goals, such as your retirement.

  • Can you make a large enough down payment? While it's now possible to purchase a home with no down payment, that's typically not a good financial alternative. If possible, strive to make a down payment of at least 10% to 20% of the home's purchase price. If your down payment is less than 20%, you'll have to pay private mortgage insurance, which can typically total .25% to 1.25% annually of your mortgage balance. Another danger with a low down payment is that if you are forced to sell soon after purchase, you may not net enough from the sale to pay off your mortgage.

  • Have you considered all costs? Besides the mortgage payment and property taxes, there are other costs involved with owning a home. You'll be responsible for all utilities, insurance, and repairs and maintenance on the home.

Several factors need to be evaluated before deciding whether you should rent or own a home.

Extending Your IRA's Life

Individual Retirement Accounts (IRAs) are typically viewed as retirement planning vehicles. But with increased contribution amounts and the ability to roll over 401(k) balances to a traditional IRA, many IRA owners are finding they won't use their entire balance for retirement. Thus, IRAs are quickly becoming major estate planning tools. When used for estate planning, the goal is to extend the IRA's life as long as possible so beneficiaries can benefit from the tax-deferred (for traditional IRAs) or tax-free (for Roth IRAs) growth.

For instance, assume you have a large traditional IRA balance, which includes a rollover from your 401(k) plan. You don't have to start taking distributions until after age 70 1/2. Then, you only take required minimum distributions calculated based on your age. When you die, you leave the IRA to your spouse, who rolls the balance over to his/her own IRA and names his/her own beneficiaries, perhaps your children or grandchildren. Your spouse then delays distributions until age 70 1/2 and then only takes required distributions. When your spouse dies, your children inherit the IRA, which can be divided into separate IRAs for each child. Each child can then take distributions based on each of their life expectancies. By taking only minimum distributions when required, the balance can continue to grow on a tax-deferred basis for years or even decades.

The concept can be expanded further by converting a traditional IRA to a Roth IRA. Although income taxes will have to be paid on any amounts that would have been taxable when withdrawn (e.g., contributions and earnings in a traditional IRA and earnings in a nondeductible IRA), the income taxes can be paid with funds outside the IRA, leaving the IRA balance intact. Then, you would not have to make any withdrawals during your life. Since your spouse can roll the balance over to his/her own IRA, he/she also would not have to take withdrawals during his/her lifetime. When your spouse dies, your heirs would then have to take distributions over their life expectancies, but those distributions would be federal income tax free, provided the distributions occurred after the five-tax-year holding period.

Don't lose sight of the fact that your IRA's main purpose is to fund your retirement. It should only be used for estate planning purposes if you don't need the funds for retirement.

What's So Unique About a Roth IRA?

Even though Roth Individual Retirement Accounts (IRAs) have been around since 1998, many investors aren't aware of all the differences between traditional and Roth IRAs. Thus, they aren't sure which IRA is the better alternative for them. As a summary, the unique features of a Roth IRA include:
  • Single taxpayers with Adjusted Gross Income (AGI) less than $95,000 and married taxpayers filing jointly with AGI less than $150,000 can make contributions to a Roth IRA, regardless of their participation in a qualified retirement plan. Contributions are phased out for married taxpayers filing jointly with AGI between $150,000 and $160,000 and for single taxpayers with AGI between $95,000 and $110,000.

  • Since contributions are not tax deductible, they can be withdrawn at any time, even before age 59 1/2, without paying income taxes or the 10% federal tax penalty.

  • Contributions can be made as long as you have earned income, no matter how old you are.

  • Qualified distributions can be taken free of federal income taxes. A qualified distribution is one made after reaching age 59 1/2 and at least five tax years after the first contribution. Distributions can also be taken free of federal income tax due to death, disability, or to pay up to $10,000 of qualified first-time homebuyer expenses.

  • There are no mandatory minimum distributions after age 70 1/2. You can take out as much or as little as you want after age 59 1/2, but you can allow the balance to grow on a tax-free basis if you don't need the money.

  • Qualified distributions from Roth IRAs are not included in AGI, so they don't affect whether Social Security benefits are subject to income taxes.

  • Roth IRAs can provide a tax-advantaged way to bequeath assets to heirs. Both traditional and Roth IRAs may be subject to estate taxes, depending on your estate's total value and who your beneficiary is. However, the beneficiaries of traditional IRAs must pay income taxes on distributions, while Roth IRA beneficiaries receive qualified amounts free of federal income taxes.

So, based on all these unique features, which is a better alternative for you -- a traditional deductible or a Roth IRA? Look at these factors before deciding:

  • Consider your current marginal income tax bracket and your expected bracket when the funds will be withdrawn. If your marginal tax bracket will be the same, either IRA will produce a similar result. Declining marginal tax rates may make a deductible IRA a better alternative, while increasing marginal rates may make the Roth IRA a better alternative.

  • If you make the maximum IRA contribution to a Roth IRA, you will have a larger after-tax balance than making maximum contributions to a deductible IRA. This occurs because you are essentially funding the tax bill with funds outside the Roth IRA. To offset the Roth IRA's advantage, you would also have to invest the tax savings from your traditional IRA contribution.

  • Don't forget the Roth IRA's other advantages. If you don't think you'll need to make withdrawals after age 70 1/2, the Roth IRA can continue to grow on a tax-free basis. Or, if you think you'll need your contributions before age 59 1/2, you can withdraw Roth IRA contributions at any time with no tax consequences.

Withdrawing Your IRA Funds

The tax laws regarding withdrawals from individual retirement accounts (IRAs) are complex. To avoid unnecessary penalties and to ensure you withdraw the funds efficiently, let's review the basics:

Before Age 59 ½

In addition to any income taxes that may be due, withdrawals before the age of 59 1/2 are subject to a 10% federal tax penalty. In certain circumstances, however, the 10% penalty will not be assessed:

  • Distributions are made to beneficiaries after the IRA owner's death.

  • Distributions are made to the IRA owner due to the owner's disability.

  • Amounts distributed equal medical expenses paid in excess of 7.5% of adjusted gross income.*

  • Distributions are made to certain unemployed IRA owners to pay health insurance premiums.*

  • Distributions are made for up to the $10,000 lifetime limit for qualifying first-time homebuyer expenses.

  • Distributions are made to pay qualified higher-education expenses for you, your spouse, your children, or your grandchildren.*

  • Distributions are made as a series of annual withdrawals in substantially equal amounts over the owner's life expectancy or the joint life expectancy of the owner and beneficiary.*

* While distributions are exempt from the 10% federal tax penalty, these types of Roth IRA withdrawals are subject to ordinary income taxes on any earnings. The other Roth IRA withdrawals are penalty free and income tax free.

Between Ages 59 1/2 and 70 ½

Between these ages, you can withdraw as much or as little as you like from traditional or Roth IRAs. Both contributions and earnings withdrawn from a traditional deductible IRA and earnings from a nondeductible IRA will be subject to ordinary income taxes. As long as the first contribution was made at least five years ago, Roth IRA distributions will not be subject to federal income taxes. Generally, you should postpone withdrawals as long as possible to continue tax-advantaged growth. However, in years when income is low, you may want to take distributions from a traditional IRA to take advantage of lower income tax rates. You may also want to convert all or part of a traditional IRA to a Roth IRA during low income years. While you will have to pay income taxes on the conversion, future earnings will accumulate tax free as long as you make qualified distributions.

After Age 70 ½

You are not required to take distributions from a Roth IRA after age 70 1/2. You must, however, take Required Minimum Distributions (RMDs) from your traditional IRAs every year or you will be assessed a 50% penalty on amounts that should have been withdrawn. You can always take more out than the RMD. Your RMD is calculated by taking the account balance as of the preceding year divided by the life expectancy factor from a uniform table. The table is based on joint life expectancies and assumes your beneficiary is 10 years younger than you. If your spouse is your sole beneficiary and is more than 10 years younger, you can use either the uniform table or a table based on the actual joint life expectancy of you and your spouse.

Your first RMD must be made by the Required Beginning Date (RBD), which is April 1 of the year after you turn 70 1/2. However, if you take the distribution in the following year, you will then take both your first and second distribution in the same year. Evaluate your tax situation before doing that. Two distributions may increase your income so you are in a higher tax bracket, lose tax deductions or credits, or have Social Security benefits become taxable. In those situations, you may be better off taking your first RMD in the year you turn 70 1/2.

After Death

Heirs must generally start taking distributions by December 31 of the year after your death. Distributions by heirs are based on who your beneficiary is and whether you died before or after the RBD:

  • If the account has a designated beneficiary, which includes individuals and certain trusts, the account balance is paid out over the beneficiary's life expectancy, based on a single life expectancy table. This calculation is used whether you die before or after your RBD. If the designated beneficiary is older than you, he/she can use your remaining life expectancy.

  • A spouse can treat an inherited IRA as his/her own, but the surviving spouse has to be the sole beneficiary. However, if a spouse and other beneficiaries inherit an IRA, the account can be split so the spouse solely owns his/her share.

  • If the account does not have a designated beneficiary, which includes your estate, charitable organizations, and certain trusts, and you die after your RBD, the balance is paid out over your remaining life expectancy. If you die before your RBD, then the balance is paid out within five years of your death.

The decisions you make regarding IRA withdrawals have important consequences for your retirement and for your heirs.


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