Using Immediate Annuities To Update An Estate Plan

One of the best and most often used estate-planning techniques is the marital deduction. You can leave as much of your estate to your spouse as you want, without limit, and owe no estate taxes. The estate tax problem doesn’t arise until the “second death,” when the surviving spouse dies.

At that point, taxes are due on the entire estate. For individuals with sizable estates, the tax problem at the second death can take a serious chunk out of what ultimately passes onto heirs. For that reason, many planners recommend that proper estate planning be done long before the first spouse dies.

There are a number of ways for individuals to avoid or reduce their estate taxes. Some gift their estates out to children and grandchildren while others use charitable remainder trusts (CRTs) to set aside assets for charities at death, while maintaining control over those assets during their lifetime.

But what if both spouses are fairly young and uncomfortable with gifting assets out of their estate? What if both want to leave their assets completely to family members, but only after the death of the second spouse?

In such cases, the answer is usually life insurance, purchased in amounts sufficient to cover any estate tax liability at the death of the second spouse. Prior to the mid-1980s, meeting this need required two life insurance policies, one on each spouse. Today, a single “second-to-die” policy insuring both husband and wife is generally used. This policy is typically owned by an irrevocable trust or the couple’s children.

But, where does that leave people who purchased single life policies prior to the advent of second-to-die contracts? Or, more keeping in line with history, what about those who purchased insurance on only one spouse?

Do they take the chance that the insured spouse will be the second to die? Or, do they take the chance that the surviving spouse will be able to “tuck the proceeds away” until taxes are due? Should they cash the old policy in, pay taxes on the gain, and use the remaining cash value to purchase a new second-to-die policy?

The answer to all three questions is no. In cases like this, the best answer may be to see whether riders can be added to the existing policy to cover a second insured. If thats neither feasible nor possible, another solution is to transfer cash values from the existing policy into an immediate annuity, via a tax-free 1035 exchange, to fund the purchase of a second-to-die policy. This concept is commonly referred to as an “annuity start.”

Consider the following recent case:

Bill and Mary Jones are in their mid-50s. After sitting down with our firm, they determine that they need a little over $3 million in liquidity to cover expenses and estate taxes at the second death. Bill, however, purchased a single life policy with a face amount of $1.5 million 20 years ago and, over the years, the contract’s cash value has grown considerably.

To meet their current estate and liquidity needs, Bill and Mary decide to purchase a second-to-die policy with a face amount of $3 million. Their plan is to pay the premiums for 20 years, and then use non-guaranteed policy values and dividends to fully fund the contract.

But theres a problem. Where will Bill find the money to pay the premiums on the new second-to-die policy? Under current tax law, he cant 1035 exchange his single life policy into a joint life policy. And, if he withdraws his existing cash value to pay the new premiums, he could very well be looking at a taxable event.

So whats the answer? Implement the annuity start, using a 1035 exchange to roll the existing policy into an immediate annuity.

By rolling his existing cash value into the annuity, a portion of each payment will be considered a tax-free return of principal. Bill can then use those payments to pay the premiums on the new second-to-die policy, covering both himself and Mary for $3 million.

In this way, Bill has funded a new policy providing over $1.5 million more coverage and he has used the cash value from his former policy to pay all or most of the premiums due on the new coverage. Should both of the Joneses die before the end of 20 years, their heirs will receive both the $3 million policy proceeds, sufficient to cover estate taxes and expenses, as well as the balance of the payments from the immediate annuity.

In short, the Joneses have taken giant steps in assuring that their assets will pass to their heirs intact.

Using the annuity start also helps the Joneses avoid transferring the cash value from the original policy into the new one as a lump sum, thus preventing the policy from becoming a Modified Endowment Contract. This adds flexibility to the new policy, relieving possible tax consequences should the need arise to access policy values in the future.

Using immediate annuities with second-to-die life insurance is an effective way to update an estate plan and provide liquidity for future expenses and estate taxes.

James H. Meaders, CLU, is president of National Insurance Brokerage, Atlanta, Ga. He can be reached at annuity@mindspring.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 10, 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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