Photo by The National Guard

Nobody likes to think about, or for that matter talk about, their own mortality. But, if something were to happen to you, you certainly would want your spouse to know about special tax benefits available to beneficiaries of Servicemembers Group Life Insurance (SGLI) and the military Death Gratuity. Also, if you spend as long as I did in the military at some point there will be a death in your unit. Having this information available for the survivors could significantly change their future lifestyle.  So, as uncomfortable as this topic is, please read on…

Legislation passed by the Congress gives special tax treatment to beneficiaries of SGLI and the military Death Gratuity. But, before we talk about the special treatment, we’ll take a look at how SGLI and the military Death Gratuity is the same as other insurance. First and foremost, insurance proceeds including SGLI and the Death Gratuity (we’ll treat the Death Gratuity as insurance for the purposes of this article) pass to the beneficiary income tax-free. So, the beneficiary will receive the entire amount of SGLI selected and the Death Gratuity. The SGLI would be considered a part of the military member’s estate. At present, there is no estate tax owed on estates less than $5 million. For most military members this means that estate taxes aren’t a concern. Additionally, an individual can pass an unlimited amount to a spouse with no estate tax consequences. Finally, as long as the military member has not named “my estate” as the beneficiary of the SGLI then there are no concerns with probate or probate taxes. Again, this is the same as with any other life insurance policy.  So what is the difference?

Congress carved out a benefit for beneficiaries of SGLI and the Death Gratuity. Beneficiaries are allowed to roll-over the amount of SGLI received and the Death Gratuity directly into a Roth IRA. There are a couple of limits on the amount that you can roll over. Essentially, if you roll over money into an Education (Coverdell) IRA that amount is subtracted from the amount you can roll-over into a Roth IRA. Also, my assessment is that if you name your estate or some other “non-person” (like a trust) as the beneficiary of your SGLI you may lose the ability to roll it over into a Roth IRA.

The rest of the us in the United States do not have that option. We must invest the funds from life insurance policies in taxable, or at best, tax deferred accounts.  A Roth IRA on the other hand can be tax-free if managed properly. The ability to invest tax-free or near tax-free could certainly improve the lifestyle of survivors. To understand how the process would work, I’ll give a couple of examples.

But…if you or someone you know is ever in this situation you’ll want to get qualified tax advice from an Enrolled Agent, CPA, or tax attorney. This is just too complicated and the beneficiary will most likely be too stressed/distraught to try this on their own. With that said, here are some basic rules for using a Roth IRA in combination with SGLI and the Death Benefit to maximize investment returns for the beneficiaries  I’ll talk about a scenario where the beneficiary does not need the insurance proceeds to maintain an acceptable lifestyle prior to retirement and the scenario where the beneficiary needs some of the money to maintain an acceptable lifestyle.

1. Beneficiary Does Not Need Proceeds Until After Retirement Age. This is the simpler of the two scenarios. The beneficiary has the option of rolling over up to $500,000 ($400,000 SGLI max and $100,000 Death Gratuity) into a Roth IRA. If the account has been open for at least 5 years and the owner is at least 59 1/2 all distributions are tax-free. There are other cases where the distribution is tax-free prior to age 59 1/2 such as a disability, but for most beneficiaries the age restriction will be the defining variable. This arrangement provides the following benefits.
• Tax-Free growth and income
• Roth distributions are not included in income. Therefore, this may reduce the taxable portion of Social Security Benefits
• A Roth IRA is a powerful estate planning tool that may allow for transfer to next generation with low income tax liability for heirs
2. Beneficiary Needs Income from Proceeds Immediately. In this case the beneficiary may (depending on age) be able to avoid taxation or at least minimize/defer it. Here is how it works. Generally speaking, if the rules mentioned above are not met, then the money withdrawn from the Roth IRA is not “qualified” and the earnings are subject to tax and a 10% penalty. But there is a way to avoid/delay the tax and penalty through the use of “substantially equal payments”. If the withdrawals meet the IRS requirements for a “substantially equal payments” then the earnings are not subject to penalty, but they are still subject to tax. However, based on the way the IRS counts the distributions, it is quite possible that the beneficiary may be able to withdraw the roll- over contributions first and then earnings. The roll-over amount is not subject to taxation or penalty. An example might demonstrate best. In our example, the beneficiary/survivor is 30 years old. Based on the IRS Uniform Lifetime Table the beneficiary’s life expectancy is 66.3 years. We’ll also assume that the beneficiary received the full $500,000 in combined benefits.

A couple of reminders: this example is for demonstration only. There are three different ways to calculate the “substantially equal payments” and even the IRS says you should seek professional counsel on this one. With that said, the example would look like this:

• Beneficiary Receives $500,000 and rolls the total amount to a Roth IRA
• Beneficiary Starts withdrawing the “substantially equal payments”. First year’s withdrawal is $7898.90 (Remember, the beneficiary may have SBP benefits as well)
• Next year Beneficiary calculates/confirms “substantially equal payment” based on method of calculation selected and makes withdrawal.
• Beneficiary will not owe income tax until total amount of money withdrawn exceeds $500,000 (and will never owe the penalty as long as the “substantially equal payments” continue) and if the $500,000 threshold is met after age 59 1/2 income taxes will not be due then either
• It is likely that the beneficiary will not withdraw more than the $500,000 prior to reaching age 59 1/2
• This results in more income available to the beneficiary, especially in early years,  as taxes will not be deducted from earnings versus using a taxable investment vehicle

In summary, this is complicated and it is a difficult thing to talk about. At a minimum, walk away from this post with the understanding that through the use of a Roth IRA you may be able to increase the money available to you (if you are the beneficiary) or for the spouse of a colleague. That is worth remembering.

Curt Sheldon is a Fee-Only Financial Planner based in Northern Virginia.  He can be contacted at (703)542-4000,   (800)928-1820 or Curt@CLSheldon.com

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication

The information contained in this blog is for general financial education and should not be construed as individual financial advice.  Please consult your own financial, tax or legal advisor prior to applying any principles discussed here to your own financial situation.