The passage of the SECURE Act 2.0 introduced significant changes to retirement planning, impacting how affluent individuals manage their qualified retirement plan assets. While these reforms aim to enhance retirement savings, they also bring new tax challenges that require proactive planning.
The planning specialists at Cedar Point Financial Services LLC have been educating their clients and their clients’ advisors about SECURE Act 2.0 on how life insurance strategies can be utilized to mitigate taxation on distributions and estate transfers of qualified retirement plan balances.
SECURE Act 2.0 and the Challenges of Large Qualified Plan Balances
Key SECURE Act 2.0 Changes Affecting Qualified Plans:
- Increase in Required Minimum Distribution (RMD) Age – The act raised the RMD age to 73 in 2023 and will increase it to 75 in 2033, providing more time for tax-deferred growth.
- New Roth Contribution Options – Plan sponsors can now allow employer matches to be made in Roth dollars, which creates future tax-free income.
- Elimination of the Stretch IRA for Non-Spouse Beneficiaries – The requirement for most non-spouse beneficiaries to withdraw inherited qualified plan funds within 10 years significantly increases the tax burden on inherited assets.
- Catch-Up Contributions with Roth Requirement – High-income earners making catch-up contributions will now need to make these contributions in Roth accounts starting in 2026.
- New Penalty-Free Withdrawal Options – Certain emergency withdrawals, terminal illness distributions, and domestic abuse-related withdrawals now have relaxed penalties.
- Enhancements for Employer-Sponsored Plans – Small businesses are incentivized with additional tax credits to set up retirement plans, expanding access to workplace retirement savings.
- Expanded 529 Plan Rollover to Roth IRAs – Allows for unused 529 education savings funds to be rolled over into Roth IRAs under certain conditions, helping families optimize tax-efficient wealth transfers.
The Problem: Heavy Taxation on Large Qualified Plan Balances
High-net-worth individuals with substantial IRA or 401(k) balances often face the problem of excessive taxation upon distribution. Here’s how taxation impacts these accounts:
- Income Taxation on Distributions: Withdrawals from traditional qualified plans are taxed at ordinary income tax rates, which can be as high as 37% federally, plus state taxes.
- Estate Taxation: If an individual dies with a large qualified plan balance, it may also be subject to 40% estate tax, in addition to income in respect of a decedent (IRD) taxes, reducing the amount passed to heirs.
- The 10-Year Distribution Rule: Most non-spouse beneficiaries must liquidate inherited IRAs within 10 years, potentially triggering large tax liabilities in their peak earning years.
- Loss of Tax Deferral Advantages: Unlike before, heirs cannot stretch distributions over their lifetime, forcing rapid withdrawals that increase taxable income.
- Impact on Charitable Giving Strategies: The compressed withdrawal window limits opportunities to use inherited retirement assets efficiently for charitable giving.
A Solution: Life Insurance as a Wealth Transfer Tool
At Cedar Point Financial Services LLC, our team recognizes how life insurance can play a central role in offsetting the tax burden associated with qualified plan distributions. The key benefits include:
- Liquidity for Taxes – Proceeds from a life insurance policy provide a tax-free source of liquidity for estate taxes and income in respect of a decedent (IRD) tax liabilities.
- Tax-Free Death Benefit – Unlike qualified plan assets, properly structured life insurance proceeds are free from income and estate taxes when owned inside an Irrevocable Life Insurance Trust (ILIT).
- Leverage and Asset Growth – Premiums paid from after-tax distributions of a qualified plan can generate a significantly after-tax result, maximizing the amount transferred to heirs.
- Asset Protection – In many jurisdictions, life insurance proceeds are protected from creditors, ensuring wealth preservation.
- Preservation of Charitable Intentions – High-net-worth individuals who want to leave a philanthropic legacy can utilize life insurance to fund charitable bequests while protecting heirs from excessive tax burdens.
Minimizing Qualified Plan Taxation for Business Owners and Their Heirs
For business owners, there is a compelling financial approach designed to reduce the tax burden associated with large IRA and qualified retirement plan balances while maximizing after tax wealth transfer to heirs. Tax-deferred accounts life IRA’s, 401k’s, and Profit Sharing Plans are subject to both income in respect of a decedent and estate taxes upon the death of the account holder, potentially eroding up to 70% of an inherited plan’s value. This approach strategically reallocates these assets to mitigate tax exposure and maximize long-term financial security—especially in light of the SECURE Act that essentially abolished the Stretch IRA by requiring 100% taxable distribution of qualified plans to most non-spouse beneficiaries within 10 years of death.
Business owners can take advantage of qualified plan funds (and/or even roll pre-tax IRA dollars into a Profit Sharing Plan) to acquire a life insurance policy within a tax-qualified plan. The strategy involves funding the policy with pre-tax dollars over a set period, then repositioning the policy into an irrevocable grantor life insurance trust (ILIT) by having the ILIT purchase the policy from the qualified plan at a discount for its fair market value, ultimately ensuring its proceeds are free of income and estate taxes. By leveraging pre-tax dollars and minimizing required minimum distributions, this approach increases legacy value while providing greater financial flexibility for affluent individuals. This approach not only preserves wealth for future generations but also hedges against potential tax rate increases, making it a valuable tool in sophisticated estate planning.
Case Study: Retirement Tax Minimization Strategy
A wealthy, 60-year-old business owner has $4 million in qualified plan assets and $2,090,000 in liquid non-qualified assets and will not need the required minimum distributions (RMDs) from his qualified plan for personal expenses. Instead of leaving the qualified plan assets as is and exposed to what could be 70% overall taxation to his children, he implements this approach:
- Purchasing a life insurance policy inside of the qualified plan – Makes five annual premium payments of $800,000 to purchase a life insurance policy with a death benefit of $9,866,000.
- Making a lifetime gift of $2.09mm to an ILIT – enough to grow to $2.568mm--equal the projected fair market value of the life insurance once it has been funded over five years.
- Repositioning the life insurance policy – the trustee of the ILIT uses the $2.568mm to purchase the policy for its fair market value, transferring the policy tax free from the qualified plan.
- Minimize taxation and wealth replacement – At the death of the business owner, his children will receive the life insurance policy’s income tax-free death benefit as well as the balance of the qualified plan instead of inheriting a highly taxed, large qualified plan balance.
By exploring with Cedar Point Financial Services LLC whether a similar strategy is a fit for you, wealth does not have to be lost due to qualified plan taxation.
Implementing a Split-Funded Cash Balance Plan
A major positive stemming from SECURE Act 2.0 is the ability to capture massive tax deductions retroactively. Business owners can establish and implement a Split-Funded Cash Balance Plan as late as September 15th of the current year to reduce taxable income for the prior tax-year. By including pension life insurance in this strategy, there are multiple benefits:
- Higher Contribution Limits: Split-Funded Cash Balance Plans allow significantly higher tax-deductible contributions than 401(k) or profit-sharing plans.
- Maximizing Tax-Deductible Contributions: Contributions to the plan, including premiums for pension life insurance, are tax-deductible to the business.
- Tax-Free Retirement Income: Pension Life insurance can be purchased away from the plan for fair market value at a discount, repositioned to provide tax-free retirement income.
Although a Split-Funded Defined Benefit Plan can accelerate retirement savings, there is some complexity. As a result, it is important for those considering implementing a plan to consult with their legal and financial advisors, including the experts at Cedar Point Financial Services LLC.
Legacy Planning: The Sale of Life Insurance from the Qualified Plan to an ILIT
A Split-Cash Balance Plan can alternatively be oriented toward legacy planning, A key to that is transitioning the life insurance policy from the qualified plan to an ILIT to ensure tax-efficient wealth transfer. The process involves:
- Partially Funding the Plan with Pension Life Insurance: During the initial funding years (typically for five years), the policy is owned by the qualified plan and it includes an estate preservation rider to increase the death benefit while it is held within that qualified plan, so therefore, negative tax consequences are avoided.
- Policy Sale to the ILIT: To prevent inclusion in the estate, the life insurance policy is sold from the qualified plan to an ILIT at a discount for fair market value (FMV). The sale must be properly structured to avoid triggering the transfer-for-value rule, which could make the death benefit taxable.
- Estate and Income Tax-Free Payout: Upon the insured’s passing, the ILIT receives the tax-free life insurance proceeds, ensuring maximum wealth transfer.
- Avoidance of Potential Trust Taxation Issues: Proper structuring prevents trust taxation complications and ensures heirs receive the full benefit.
We Are Here to Help
The SECURE Act 2.0 presents new challenges for affluent individuals with large qualified plan balances. Life insurance often provides an effective tool to mitigate taxes on distributions and estate transfers and to prevent the erosion of wealth. Strategies such as soaking up qualified plan money to fund large life insurance policies and/or taking advantage of Split-Funded Cash Balance Plans with the eventual sale of the policy to an ILIT allow business owners and professionals to optimize tax efficiency while preserving wealth for future generations. Take the first step by contacting Cedar Point Financial Services LLC to learn more.