For many people, the cash values of their life insurance policies have grown to the point that they are substantial nest eggs. This can represent a golden opportunity. In many cases, the cash value of your life insurance may be very close to the death benefit. For example, if you bought a whole life policy 20 or 30 years ago with a $100,000 death benefit and the cash value has now grown to $70,000, the net death benefit is only $30,000 ($100,000 death benefit minus the $70,000 that already belongs to you).
People are living longer, and the cost of life insurance has decreased. You are allowed to do a tax free exchange of your $70,000 cash value to a new life insurance policy, and that could increase your death benefit from a net of $30,000 to as much as $200,000, depending on your age and health. The death benefit will be greater and it will be paid income tax free to your beneficiaries. This is a huge gold nugget in the tax code.
If you have several old life insurance policies, they can all be consolidated into one larger policy. Here is the best part; when you do this, in most cases, you will no longer need to pay life insurance premiums. The new policy will have cash values, just like the current policies. These cash values can be used for emergencies, to provide retirement income, or for any other purpose. If you need to make a beneficiary change, you only have to do it once. This decreases the chance of making beneficiary mistakes.
Simplification through Consolidation
Having too many accounts is just too much to worry about, but there is a simple solution. Multiple retirement accounts can be consolidated into two basic categories: Qualified and Non-Qualified.
Qualified accounts include IRAs, 401(k)s, 403(b)s, 457(b)s, SEPs,and similar accounts where you did not pay income tax on your contributions. All of these qualified accounts can be consolidated into one easily managed IRA. The Non-Qualified category includes everything else. Many retired workers, or those planning to retire, can consolidate multiple accounts into two easily managed retirement accounts (and a third account for those who own a Roth IRA).
If you choose to consolidate some of your retirement accounts to make life a little simpler, you will need to consider how you will transfer funds from one account to another. There are two methods of transferring retirement accounts, and there are different rules for each.
1. Trustee to Trustee Transfer: This is the safest way to transfer your retirement accounts. Using this method, the funds are moved directly from the current financial institution to the new one that you choose. You simply complete the transfer request and the rest is on autopilot. You will not receive a check or need to create a paper trail to prove to the IRS that this is a transfer and not a taxable distribution. Another advantage is you can make these types of transfers as often as you like, so if you change your mind you can transfer your savings somewhere else. This method may take a little more time, usually 20 to 45 days, but you don’t run the risk of needing to prove that the transfer did not trigger a taxable event.
2. IRA Rollover: This method is faster, but there are two major tax traps. When doing an IRA rollover, the current custodian will send you a check and you must reinvest the funds into a new IRA within 60 days. If you pass the 60 day deadline and fail to reinvest the money into a new IRA, the IRS will have a big payday. The funds will lose their tax-deferred status and will become taxable immediately. The second tax trap is that you may only do one rollover in a 12-month period. Even if you have more than one IRA, you are still limited to one rollover per year. If you do more than one rollover during the 12-month waiting period, the IRA would become taxable. If after completing an IRA rollover, you decide to move your IRA again, the only safe option will be to do a trustee to trustee transfer, or wait until the 12 months have passed.
Here are two examples of how easily you can step into these tax traps:
Tax Trap 1 – “The 60 Day Limit”
Jim, age 63, owned a $200,000 IRA in a brokerage account. He had lost a little over $8,000 in the past year and was ready to take an early retirement. He decided he had lost enough and he initiated an IRA rollover. His plan was to move the account to a bank CD to keep his money safe. He received the check from the brokerage firm on March 1, 2013, so he had until April 30, 2013 (60 days later) to deposit his IRA at the bank.
On March 19 Jim retired from his company and he and his wife took a long and well-deserved vacation. When they returned from vacation, three weeks later, Jim’s wife began to have some health issues and he was focused on getting her the best care available. The 60-day deadline to reinvest his IRA had passed unnoticed, and the tax trap was triggered. Jim’s entire $200,000 IRA became taxable.
Tax Trap 2 – “One IRA Rollover per Year”
Elizabeth, a widow age 66, was married to a very conservative investor who believed in one motto, “Never take chances with money.” His $400,000 IRA was in a money market account that was paying a low interest rate. The money was safe, but the earnings were poor. Elizabeth had always been more of a risk taker than her husband and, many times, she encouraged him to take a little more risk to increase the potential earnings. After her husband’s death, Elizabeth chose to become the new IRA owner. The stage was set and she was ready to reposition the IRA for better growth. At that time the six-month bank CD interest rates were much higher than her money market account so she instructed the financial institution to send her a check for the entire $400,000, which she deposited into the CD within the 60 day limit. Elizabeth was pleased with her decision.
Several months later, a friend told Elizabeth that she had earned more than 14% in a mutual fund last year. That is the kind of growth Elizabeth was looking for. After the six-month CD matured, Elizabeth went to the bank and withdrew the CD, placing the money in the mutual fund, again within the 60-day limit. What did Elizabeth do wrong? She made two IRA rollovers within the 12 month period and triggered a tax trap. Elizabeth now owed income tax on the entire $400,000.
As bad as both of these tax traps are, they could have been much worse. If Jim in tax trap 1, or Elizabeth in tax trap 2, were under age 59., they would have paid an additional 10% penalty for taking a pre-59. distribution from their IRAs.
For Elizabeth, who was 66, the additional taxable income generated from her IRA mistake, would easily be sufficient to push her into a higher tax bracket and increase the tax on her Social Security benefits.
IRA mistakes are easy to make with only one account. If you own multiple retirement accounts, the chance of triggering an unwanted taxable event is significantly increased.
For many years, financial pundits have touted the maxim that diversification is the best way to prepare for retirement. “Don’t put all of your eggs in the same basket.” During the accumulation years, that made perfectly good sense; however, when you decide to retire, diversification needs to give way to preservation. It’s all about having enough income for a comfortable retirement. Here is the simple truth: You cannot have a guaranteed income from a non-guaranteed account! A drop in the market, like we saw in 2008, for many retirees can mean reduced retirement income. Consolidating retirement accounts in a safe place can help avoid costly and irreversible retirement mistakes.
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