Using VAs For Residual Wealth Transfer

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In Nathaniel Hawthornes The Scarlet Letter, Hester Prynne, as punishment for acts committed, is required to stand on a platform before her congregation and townspeople wearing on her garments an elaborately embroidered letter “A” as a way of memorializing the wrongful deed she had committed.

Reading the columns of many financial pundits over the years, who opine over the correct and incorrect use of variable annuities as a part of a clients overall financial plan, one would come to the conclusion that the financial professionals who sold VAs to clients who ultimately died as the owner of that product should share a fate similar to Mistress Prynne–by having to stand in front of a group of their peers with the letters “VA” elaborately embroidered on their garments.

The rationalization of such opinions stems from the tax consequences that the beneficiary of that annuity will incur upon death of the owner. When the proceeds of a VA are passed to the beneficiary in a lump sum, all gain is taxable as ordinary income.

This is contrary to a capital asset, such as an individual stock or mutual fund, where the beneficiary receives a stepped-up cost basis. And also different from a life insurance policy, which, if properly structured, results in a tax-free distribution of the proceeds to the beneficiary.

The favorable tax consequences bestowed upon the capital asset or insurance policy relative to the annuity is the reason why many professionals have a problem with wealth accumulated inside an annuity being passed on to a beneficiary.

There are a couple of problems with the critics’ line of thinking. First, capital assets such as mutual funds do not receive the ongoing benefit of tax deferral on portfolio distributions or portfolio reallocations. As a result, the owner of the annuity can accumulate wealth more quickly than the owner of the capital asset.

Second, new riders such as earnings enhancement death benefits will pay a percentage of the gain in the annuity contract to the beneficiary, thus providing a source of liquidity to help pay taxes.

A true comparison of where one comes out ahead requires an analysis of expense ratios of the mutual fund versus the variable annuity, the tax efficiency ratio of the mutual fund, the holding period for the assets, the frequency of portfolio re-allocations, and the ordinary income tax rate of the beneficiary when the asset is inherited.

There are an infinite number of scenarios around this, and the detailed planner will perform those analyses before making product recommendations. I believe the introduction of these new “tax riders” on annuities has tilted the playing field in favor of annuities.

Third, for the great majority of the investing public the combination of longer life expectancies, a decline in employer provided guaranteed retirement plans, and normalized equity investment returns, make providing a retirement income for 20 years a considerable challenge. As a result, for many in the “mass” market, transferred wealth often becomes the residue of an asset utilized to fulfill a primary goal such as retirement.

For clients who can say with certainty at age 50 or 55 that an asset in question will definitely not be needed to support a retirement income stream, it goes without question that a properly structured life insurance policy will yield a more favorable wealth transfer tax situation than an annuity.