Life insurance and Roth IRAs are both effective tools for wealth transfer, allowing you to efficiently transfer of assets from one generation to the next tax-free. However, their similarities largely end there. Despite their general resemblance, the rules that apply to life insurance don’t always apply to Roth IRAs. In fact, this is the case more often than not. Below, we outline three main differences in their structure that make these two retirement planning vehicles so different.
1. Estate Inclusion
Roth IRAs Are Always Included in Your Estate:
Due to the current $13.61 million federal exemption amount, which allows a substantial amount to pass estate tax-free to beneficiaries, the majority of Americans won’t owe federal estate tax upon death. However, a small segment of the population still faces estate tax concerns, especially in states like Minnesota with lower state estate tax exemptions ($3 million). In such cases, life insurance can offer a distinct advantage over Roth IRAs.
The “I” in IRA stands for “individual”. This means it’s always yours, and the value of your Roth IRA is always included in your estate. If your estate exceeds the federal or applicable state estate tax exemption amount, your beneficiaries could owe estate tax on what were thought to be “tax-free” Roth IRA assets.
Life Insurance Can Be Excluded from Your Estate:
Life insurance can be structured to remain outside your estate, providing a tax-free benefit to your heirs that is not subject to estate tax. This can be achieved through various methods, such as having an irrevocable trust purchase the life insurance policy. Consulting with your insurance advisor, Secured Retirement tax professional, estate planning attorney, or all three can help determine the best approach for your situation.
2. Contribution Limits
Roth IRAs Have Contribution Limits:
When contributing to a Roth IRA, you face strict limitations. For 2024, contributions are capped at $7,000 ($8,000 if you are 50 or older by year-end). However, you can convert existing IRA or eligible retirement plan funds to a Roth IRA. Additionally, Roth IRA contributions are subject to income restrictions. Roth IRA contributions can only be made with income that qualifies as “compensation,” which is typically earned income. So, if you have too much income from any one source, you can be prohibited from making Roth IRA contributions.
Life Insurance Has No Contribution Limits:
Life insurance is not bound by the same restrictions, but insurance carriers may limit the amount you can purchase based on factors like health, annual income, and net worth. As far as Uncle Sam is concerned, you can have as much insurance as you want, or perhaps, as much as you can get. You can purchase as much life insurance as you are eligible for, providing greater flexibility compared to Roth IRAs. Life insurance premiums can be paid with any type of income, including interest, dividends, and Social Security, none of which are not considered compensation.
3. Required Minimum Distributions (RMDs)
Roth IRAs Have RMDs for Non-Spouse Beneficiaries:
Non-spouse beneficiaries of a Roth IRA, such as children, must generally withdraw the entire account by December 31 of the tenth year after inheritance. While these distributions are usually tax-free, they are mandatory.
Life Insurance Has No RMDs:
Beneficiaries of life insurance do not face required minimum distributions. They receive the proceeds tax-free, but any subsequent investments of those proceeds may generate taxable income unless invested in non-taxable assets like municipal bonds.
Example:
Someone inheriting a Roth IRA at age 50 can leave it to grow for 10 years, with tax-free growth and tax-free distributions thereafter. In contrast, a $500,000 life insurance policy provides only the initial proceeds tax-free. A $500,000 Roth IRA, if left to grow, may double in value, providing tax-free distributions potentially worth more than the life insurance payout.
A Final Thought
When planning to leave a legacy, there are many tools to consider, including life insurance and Roth IRAs. At Secured Retirement, we know that each situation is unique, and there is no one-size-fits-all solution. Consulting with our professionals can help tailor a plan to your specific needs and goals so that you can pay taxes consciously, spend confidently, and ultimately, retire comfortably. To discuss your life insurance vs Roth IRA strategy, give us a call: 952-460-3290.
