Permanent life insurance policies (often referred to as “Whole Life Insurance”) are a contract between a policyholder and an insurance company whereby the insurance company promises to pay a designated beneficiary a sum of money (a death benefit) upon the death of an insured in exchange for a premium. In most cases, when the designated beneficiary receives the death benefit, the life insurance proceeds are usually “tax-free” and do not need to be reported as taxable income on the beneficiary’s income tax return.
While the taxation of life insurance proceeds at death are generally tax-free, there are times during the life of an insurance contract when the owner of the life insurance policy may be subjected to income tax. With whole life insurance, part of the premium that you pay goes toward the cost of the life insurance and part of the premium goes to an investment component in the policy (i.e., build-up of cash surrender value). With every premium payment, this “cash surrender value” of the policy continues to grow. The IRS does not tax the gains on a whole life insurance policy (dividends or build-up of cash surrender value) as long as the gains stay in the policy. However, if you choose to take out a “loan” against the policy or choose to receive dividends paid out to you in cash, there is the possibility that you could be subjected to income tax in certain situations.
Net unrealized appreciation (NUA) is a favorable tax planning opportunity that can often save a taxpayer tens of thousands of dollars. However, this tax planning opportunity is often underused because most people are unaware of its existence. In order to utilize this tax planning opportunity, an employee must own company stock in his or her 401(k) account. Other company-sponsored retirement plans may also apply when discussing NUA, but the primary type of account is the 401(k) so this is what we will address here.
For many employees that participate in a company-sponsored 401(k) plan, when they retire or terminate employment with the company, they would choose to “rollover” the entire balance of their 401(k) account into a self-managed IRA. However, when the employee owns company stock in their 401(k), they should analyze whether this is the best thing to do. Net unrealized appreciation (NUA) is simply the difference between the cost basis (what you paid for the stock) and the current fair market value of the employer stock in your 401(k) account. The IRS allows for this net unrealized appreciation to be treated as a capital gain, which is taxed at lower tax rates than ordinary income tax rates. The larger the appreciation of the employer stock in your 401(k) account, the bigger the opportunity to save more in taxes by utilizing this strategy. For example, if you retire with $750,000 of employer stock in your 401(k) account and this stock only has a cost basis of $150,000, you would have net unrealized appreciation of $600,000 in this stock.
Beginning in 2015, taxpayers can only make one 60-day “indirect” IRA-to-IRA rollover per 12-month period (not based on a calendar year) regardless of the number of IRAs that you own. Prior to 2015, many taxpayers followed Proposed Treasury Regulation Section 1.408-4(b)(4)(ii), published in 1981, and IRS Publication 590-A (“Contributions to Individual Retirement Arrangements (IRAs)”) which interpreted the limitation of one 60-day IRA rollover per 12-month period as applying on an IRA-by-IRA basis, meaning that a rollover from one IRA to another would not affect a rollover involving other IRAs of the same individual. However, a tax court case in 2014 trumped these interpretations by ruling that you could not make a non-taxable 60-day (“indirect”) rollover from one IRA to another if you had already made a similar rollover from any of your IRAs in the preceding 12-month period (Bobrow v. Commissioner, T.C. Memo 2014-21). As a result of this Tax Court ruling, followed up by guidance from the IRS in Announcement 2014-32 (issued on November 10, 2014), it is now crystal clear that the new rule applies in the aggregate to all IRAs.
“Direct” IRA-to-IRA Transfer Exception
According to Genworth Financial, a major issuer of long-term care insurance policies, a private room in a nursing home averages $92,378 ($253/day) in 2016 while a home health aide, who works under the supervision of a registered nurse or therapist to assist with daily routines such as bathing, grooming, dressing, and medication reminders, averages $46,332 ($127/day) in 2016. As astronomical as these costs appear now, they are only going to get larger as baby boomers age and the demand for this care grows. Over the past 5 years (2012-2016), the annual cost for a private room in a nursing home has averaged a 4% increase per year. Based on a current annual average cost of $92,378 in 2016, a 3-year stay in a private room of a nursing home would cost a whopping $277,134, assuming that prices don’t continue rising. Contrary to popular belief, Medicare and other forms of health insurance do not cover these health care expenses because long-term care is not considered a medical expense. Therefore, unless you are confident that you can pay for this care yourself, you may want to consider purchasing some form of long-term care insurance (LTCI).
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