Combine Annuities And Life Insurance For Your Clients Estate Plans

Annuities are terrific wealth accumulation vehicles. For this reason they have been popular with clients looking to build retirement accounts. After all, annuities allow for tax-deferred growth, the ability to switch among multiple subaccounts, and other popular features such as a death benefit.

Too often, however, clients and advisors only look at annuities for their accumulation benefits and ignore an annuity contracts other key strength–their annuitization feature. Many modern annuities offer a range of annuitization options, the ability to reset an annuitization approach and the ability to commute the contract. In addition to income benefits, annuitization also offers another key advantage for clients–estate planning.

These can be used to turn an annuity to a clients advantage as an estate planning tool.

Chances are, if your client has an existing annuity it was purchased for retirement income. Very often a clients situation has changed since that annuity was purchased. If your client has other sources of income (for example, a pension or an IRA, that they must begin to draw on) that annuity will go untouched. They may be very happy with the tax-deferred growth they enjoyed in most recent years and want to pass the value of the annuity on to their family. However, the tax-deferred growth enjoyed by annuities is a double-edged sword.

Like an IRA, at some point income taxes must be paid on the annuitys appreciation. If this is not paid during your clients lifetime, it will be by the heirs or the estate. Since the appreciation will be taxed sooner or later, one approach would be to expose some dollars to taxation today, with overall better results for the heirs.

Without the additional planning necessary for annuities that might otherwise be left to grow, the erosion from income and estate taxes can be a significant problem. In large estates the erosion can be over 70%.

Consider the following example using a typical annuity: Your clients, Tim and Mary, are in the top tax brackets. Some years ago they invested $150,000 in an annuity and are very happy with its growth. The annuity is now valued at $375,000. Both Tim and Mary are 70 and the couple is living comfortably on their other assets. Tim doesnt need the annuity and he realizes that the annuity is an asset in a very sizeable estate that is likely to be taxed at the top estate tax rate. The couple is particularly upset to learn that the annuity will also be consumed by income taxes when their children draw on it.

All of this erosion will reduce the annuity to less than a third of its value. Should the owners die today, a significant portion of the value would be consumed by taxes. (See Table 1.)

In fact, without further planning, the heirs would walk away with little less than the couples initial investment into the annuity contract.

This erosion doesnt end with just the current values. This same result persists in later years. Assuming a conservative 8% growth (net of expenses) and the top estate and income tax rates, the results are magnified. If Tim and Mary continue to allow the annuity to grow, without planning, for another 20 years, under the current tax law their heirs will see an erosion of more than 70% of the annuity value. These values are also found in Table 1.

However, the couple can proactively address this issue. Knowing that the income tax is due eventually on the annuity, Tim and Mary annuitize their contract. He then uses the after-tax portion of the annuity payments to purchase life insurance as wealth replacement planning to benefit his heirs.

Consider what would happen if the couple annuitized their contract. Under a single life annuitization option Tim might receive $46,500 in annuity payments; this is roughly the national average. Assuming Tim is in the top income tax brackets, the payout would net out to a little more than $30,000. If this amount purchased $750,000 of life insurance and Tim were to position the life insurance outside of his estate, he could redeploy the value of this annuity asset into the hands of the heirs through the life insurance death benefit, boosting the amount received by his heirs from $142,500 (without any planning) to the death benefit amount of $750,000. (See Figure 1.)

Of course, Tim and Mary could use a second-to-die policy to further leverage the death benefit available to their heirs.

Under this strategy the couple forced funds out of the annuity early. Although this reduces the amount of dollars growing in the annuity, they are able to successfully move the after-tax dollars out of his estate. This could be done through gifts to an irrevocable trust or directly to the couples children. The early access, coupled with leveraging the after-tax funds through life insurance provides Tims heirs with a much greater after-tax return.

This approach sometimes runs against the conventional wisdom of many clients. For years these clients have been “trained” to avoid income taxation. However, sooner or later these tax-deferred annuity assets will face annuity taxation. By doing some advanced planning and triggering the tax early, a client is able to turn a tax concern into a positive.

Under this approach, combining life insurance with an annuity payout offers clients an attractive means to address their overall planning. It addresses the tax problem faced by the annuity through additional planning. The life insurance can then be used to leverage the annuity payout for an overall larger benefit for the clients heirs.

Depending on how the numbers fall, this approach can also be utilized to help address a clients other estate planning costs, all through converting assets from taxable items into tax-advantaged assets owned outside of the estate.

Consider your client base and see who might benefit from this strategy.

Mark A. Teitelbaum, JD, LLM, CLU, ChFC, is second vice president, advanced marketing at Travelers Life and Annuity, Hartford, Conn. Mark can be reached via e-mail at MCLBTeitelbaum

@attbi.com


Reproduced from National Underwriter Life & Health/Financial Services Edition, May 6, 2002. Copyright 2002 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.