A financial planning benefit all military families should know about

If your client serves in the armed forces or has a loved one who does, there is a unique benefit available to heirs of active military you should know — in case the worst happens.

The life-insurance proceeds received by beneficiaries of military members, who die while serving, can be directly rolled over into a Roth IRA or Coverdell Education Savings Account. It can be done regardless of contribution limits and provides access to tax-free investment growth and withdrawals down the line.

“You can’t do this with any other life insurance,” says Eric Bond, a wealth advisor with Bond Wealth Management in Long Beach, California. “It is a very odd but great rule, if it makes sense for the beneficiary to use. The only bummer about the whole thing is how few people know about it.”

Who qualifies:

This special tax treatment applies only to military death gratuities and Servicemembers Group Life Insurance (SGLI) payouts, meaning the recently deceased armed service member must have been actively serving, be a certain reserve status, or have been discharged within the past 120 days.

SGLI coverage of $400,000 is automatically granted to individuals who are:

• An active-duty member of the Army, Navy, Air Force, Marines, or Coast Guard, or
• A commissioned member of the National Oceanic and Atmospheric Administration (NOAA) or the U.S. Public Health Service (USPHS), or
• A cadet or midshipman of the U.S. military academies, or
• A member, cadet, or midshipman of the Reserve Officers Training Corps (ROTC) engaged in authorized training and practice cruises, or
• A member of the Ready Reserve or National Guard, assigned to a unit, and scheduled to perform at least 12 periods of inactive training per year, or
• A volunteer in an Individual Ready Reserve (IRR) mobilization category

Servicemembers, however, can decline the coverage or elect lesser amounts, meaning a beneficiary might not be entitled to that full $400,000 payout.

Finally, a death gratuity, equal to $100,000, may also be paid out to the survivor of an active armed forces member. Certain reservists may also qualify if the death occurred while traveling to or from active duty, or while on inactive-duty training, for instance.

How to use it:

Altogether, a widow or other beneficiary could have a total of $500,000 in tax-free income to deposit into a Roth IRA and Coverdell Education Savings Account, which could dramatically reshape their future financial picture and retirement security.

The beneficiary can split these payouts between the ESA and Roth IRA as they see fit, contributing a portion, all, or nothing to each. Alternatively, they can also reserve a chunk for immediate expenses by leaving it within a checking or savings account.

They just need to watch that the total amount contributed to the ESA and Roth IRA does not exceed the total benefit amount they received, otherwise they’ll have to remove the excess contributions to the Roth IRA.

This is why Elijah Kovar, co-founder of Great Waters Financial in Minneapolis, recommends working with clients to determine what portion of the benefit they want to place in each type of account prior to making any contributions, and then funding the ESA before the Roth IRA.

Contribution limits do not apply, nor do annual income limits for funding a Roth IRA. So an individual earning $210,000 the year their military loved one passes and who receives a $50,000 SGLI benefit, for example, could contribute the whole sum to a Roth IRA, even though under normal circumstances only $6,000 (or $7,000, if age 50 or older) can be placed in the account annually — and they would otherwise be ineligible to contribute at all because their income is so high.

Clients do have a limited timeframe to make the move though. Funds must be deposited into a new or existing ESA or Roth IRA within one year of the beneficiary receiving it, otherwise they forfeit the opportunity to do so. (A separate one-year deadline applies to each benefit received.)

Finally, the funds can be tapped at any time within the Roth IRA without incurring taxes or a penalty, as they are treated like any normal contribution. This is why the move makes sense for almost everyone, Kovar says, because they can still easily access it while it grows tax free.

However, the earnings on that money will be subject to income tax, if removed before the account is five years old, and a 10% early distribution penalty, if under the age of 59½.

“It is a phenomenal benefit that gives military families the chance to have potentially hundreds of thousands of dollars grow tax free but, sadly, not a lot of them know about it,” says Kovar. “You don’t hear of many people who’ve taken that money and actually put it in a Roth.”