While annuities can be used to provide supplemental income for your clients, we also use annuities in our clients’ estate planning, which has developed into one of our specialties.

How do we incorporate variable annuities into our plan, Eight Steps to Zero Estate Taxes and Asset Protection? Step 1 is “maximize your living trust.”

By that we mean to make the most of the A-B trust arrangement that has become common in estate planning. That is, a B trust, sometimes called a family trust or bypass trust or credit shelter trust, is created to receive the unified exemption amount at the client’s death. In 2000 and 2001, up to $675,000 worth of assets can pass to the next generation through this B trust, free of estate tax.

This trust becomes irrevocable when it’s funded. Subsequently, no matter how big this trust grows–to $2 million, $3 million, $6 million or more–it will continue to be exempt from estate tax.

Therefore, your clients will want this B trust to be a growth trust, funded with the most outstanding growth assets available in America.

Assets left in this B trust receive a stepped-up cost basis at the owner’s death. That is, these assets can be sold and no capital gains tax will be due. Then the full proceeds can be reinvested in equities, for future growth.

In the meantime, the surviving spouse can live off the A trust, or marital trust, which also escapes estate tax. We call the A trust the shrinking trust because the family will be well served if the surviving spouse spends down this trust while allowing the B trust to grow.

Now, here is where variable annuities come into play. Because our plan calls for the B trust to grow, untouched, we want to make sure the A trust provides a source of income that the surviving spouse can never outlive. This, of course, is the variable annuity, either in its growth stage or the annuitization stage.

Therefore, when we start estate planning for a client, we look for assets we can use to buy variable annuities: mutual funds, securities, money market funds, CDs, etc. We aim to place anywhere from $100,000 to $500,000 in two to four of the annuities in our portfolio, with the idea that those annuities eventually will go into the A trust, where they will remain.

In addition, we sometimes will recommend a variable annuity for a portion of a client’s IRA. We do so because of the principal guarantees at death for both spouses and perhaps for living benefits as well, depending upon current market conditions and the client’s risk tolerance.

Our entire practice is based upon estate planning. In fact, we charge new clients an up-front fee for an estate plan.

With this emphasis on estate planning, annuities are very important to our firm. Variable annuities held in the A trust, as described above, can give the surviving spouse an immediate source of income. As you all know, an estate planning case may take as long as six months from the scheduled date of the medical exam to the date the trust documents are finished and the life insurance is finally placed.

With the surviving spouse provided for by the annuities in the A trust, we can focus our efforts on “super-charging” the B trust, maximizing the amount that can be passed on to succeeding generations, tax-free.

It’s true that annuities might pose estate planning problems because they don’t receive a stepped-up basis at death. We may plan around this by having clients select the guaranteed income option for their children, which is irrevocable. Thus, the deferred income tax will not be due at the client’s death, but will be spread out over the child’s life expectancy.

We also may recommend leaving some of a client’s unified credit intact, so that bequeathing an annuity won’t trigger estate tax. However, in some cases it is inevitable that estate taxes will have to be paid; if that’s the case, we work extensively to familiarize our clients and their tax professionals with income in respect of a decedent, or IRD, so that income tax deductions may be taken to offset estate taxes paid.

In that regard, annuities are similar to IRAs, which also do not receive a stepped-up basis at death. Indeed, we place great emphasis on our IRA planning program.

All of our clients know how many lives a cat has: nine. However, none of them know how many lives an IRA has: three.

The first life of an IRA is the accumulation and distribution stage while the plan participant and spouse are still alive.

The second life of an IRA is the spousal rollover, when it goes to the surviving spouse, who gets a fresh start. During this stage the children are named as beneficiaries. For purposes of calculating minimum distributions, they are deemed to be 10 years younger than the surviving spouse. At this point, we highly recommend that the IRA be divided into smaller IRAs, so that each child can be the sole beneficiary of one IRA, while the surviving spouse receives income from all of these IRAs.

The third life of the IRA is the inherited IRA. As part of the plan, each child will receive an IRA. At this point the 10-year rule no longer applies, so each child can take minimum distributions over the balance of his or her remaining life expectancy.

To make sure that an IRA has all three lives, which effectively changes an IRA into a multi-generation maximized IRA, or super-charged IRA, the client must have an outside pool of money that can pay the estate tax when it’s due. What better outside pool of money than a life insurance policy held in an irrevocable trust? Depending on the circumstances, the policy can be second-to-die or single-life insurance.

Many of our clients not only have annuities and IRAs, they have more money than they or their spouse will ever need. Thus, our estate planning often involves the establishment of private foundations or charitable trusts while their children and grandchildren are taken care of through a family limited partnership and a Wealth Trust, a multi-generation dynasty trust.

If such clients hold variable annuities, we might suggest our annuity recapitalization plan. In essence, we suggest that they roll a fixed or variable deferred annuity into an immediate annuity. They can choose the maximum lifetime payout (a payout with no refund) and transfer the payments they receive to a Wealth Trust.

The Wealth Trust, in turn, can buy life insurance on the annuitant. Often, the amount of insurance that can be bought will be twice the value of the annuity contract.

That is, with an annuity worth $200,000, a client might recapitalize the annuity and wind up insured for $400,000. Inside a Wealth Trust, the $400,000 in insurance proceeds won’t be taxed.

By contrast, a $200,000 annuity might be worth only $80,000 at death, after estate and income taxes. Therefore, this strategy generates $400,000 rather than $80,000 for the family, a five-to-one return, even for clients as old as age 80.

Over the years, we have discovered that the biggest buyers of life insurance in America are wealthy families and giant corporations. They know that life insurance is a vehicle that takes assets subject to income tax, capital gains tax, and estate tax, then eliminates all of those taxes through the use of an irrevocable trust.

Even if an investor merely trades dollars with an insurance company–pays $1 million in premiums for $1 million in death benefits, for example–the ability to wash taxable funds into tax-free funds offers a return of approximately three-to-one.

Andrew D. Westhem, CLU, is a partner of the Westhem Grant Group and is chairman and CEO of Wealth Transfer Planning, San Diego. He can be reached at andrew@wealthservices.com. This is an abridged version of a presentation he gave at the MDRT annual meeting in Toronto.


Reproduced from National Underwriter Edition, June 22, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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