Three Planning Ideas

Examining strategies for avoiding early-retirement penalties, rolling over life insurance proceeds, and more.

By Natalie Choate  9-13-2013

Planners who work with retirement benefits often come up with creative ideas for helping their clients maximize the value of those benefits. Here are three that I recently received. Note that the questions are paraphrased and do not reflect the exact facts presented to me.

Do these ideas work? You be the judge!

Idea No. 1: If an employee who has not yet attained age 55 is fired or quits his job, I know he is not eligible for the "early retirement" exception that shelters some distributions from the 10% tax on pre-age-59 1/2 distributions. To preserve his potential eligibility for that exception, can he start a new business, have the new business adopt a qualified plan, and roll his benefits from the old employer's plan into that new plan, then take the money out penalty-free if he retires after age 55?

Comments: As you know, if an employee terminates his employment at age 55 or later, he can receive distributions from the former employer's qualified retirement plan penalty-free under the "early retirement" exception (one of the 13 exceptions to the 10% penalty on pre-age-59 1/2 distributions). And as you also know, if service is terminated before age 55, he totally loses eligibility for that exception--even if he waits until age 55 to take out the money, the exception won't apply because he "retired" prior to age 55.

As for the planning idea, it basically does work. The former employee can get a new job, roll the old plan money into the qualified retirement plan at his new place of employment, and then retire from the new job after he eventually reaches age 55, accessing his money penalty-free. The problem is, not everyone is capable of starting a new business, incorporating it, and causing the new company to adopt a new qualified retirement plan. The "new job" could not simply be self-employment, because it's not clear how a self-employed person ever meets the definition of "retired"; that's why I'm suggesting he would have to incorporate his new business to use this idea. And obviously if there is no real "business" (i.e., income-generating), this idea is a nonstarter.

Idea No. 2: If a surviving spouse receives life insurance proceeds as part of the death benefit payable to her under her deceased spouse's qualified retirement plan, can she roll that over tax-free into a Roth IRA? What if the beneficiary is a non-spouse designated beneficiary--for example, the decedent's child? Can he or she have the insurance proceeds rolled directly into a Roth IRA? This would seem to be a way to achieve an inherited Roth IRA with little income tax impact if it is allowed.

Comments: As you know, life insurance proceeds paid under a qualified plan to the surviving spouse or other beneficiary of the deceased employee are not totally income tax-free (unlike life insurance proceeds paid outside of a retirement plan, which are totally income tax-exempt under § 103). Proceeds of a plan-owned life insurance policy are tax-free only to the extent of the "pure" death benefit amount. The amount of the cash value of the policy immediately before the employee's death is taxed as ordinary income, just like any other retirement plan distribution. However, even so, rolling over plan-owned life insurance proceeds into an inherited Roth IRA would be a very cheap (though not totally tax-free) way to acquire an inherited Roth IRA.

I am unable to find anything in the Code or IRS Regulations that would prevent or prohibit this type of rollover. Once upon a time, nontaxable plan distributions were not eligible for rollover, but that prohibition was repealed years ago--and the repeal did not contain any exceptions for life insurance proceeds as far as I can see. I'm not saying I want to be the first one to try it, but I'm darned if I can figure out why it wouldn't work.

Idea No. 3: For Medicaid-planning purposes, my client (age 74) wants to invest his entire IRA into a three-year fixed annuity. The client would like to take the payments under the annuity contract, treat part of each payment as his minimum distribution for the year (using the value of the contract as his "account balance" value), and roll the rest of the annuity payment back into another IRA for continued tax deferral. However, you have stated in seminars that all the payments under the annuity contract would be considered "minimum required distributions," not eligible for rollover. Is that in fact your position?

Comments: If all or any part of an IRA account balance is used to purchase a true annuity, two consequences flow: First, all payments under the annuity contract are considered minimum required distributions and thus are not eligible for rollover. Second, if only part of the IRA balance was used to buy the contract, then (beginning the year after the purchase occurs) the non-annuitized portion of the IRA must continue to pay minimum distributions computed in the regular way; the annuity contract value is excluded from the account balance valuation, but the annuity payments don't "count" toward the minimum required distribution for the non-annuitized portion of the account.

The regulations seem to be mainly designed for an individual who is taking an annuity for his lifetime or a joint and survivor life annuity with his beneficiary. However, they also clearly apply to the purchase of a fixed-term annuity, such as the one your client is contemplating. Unfortunately there does not seem to be any exception for the purchase of a short-term annuity. Thus, even though your client could have purchased a much longer-term annuity with much smaller annual payments, if he buys a three-year fixed-term annuity when he is older than age 70 1/2, he is going to be stuck with non-rollable distributions liquidating his entire balance in three years.