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September 30, 2004 at 08:00 PM
Power Tool Combo: Life And Annuities Together
Without proper planning, taxes can diminish a persons wealth before it is transferred to heirs, particularly when financial instruments such as annuities are subject to income or estate taxes at the owners death. While annuities are excellent wealth accumulation devices, they are inefficient wealth transfer devices.
However, one can transfer wealth efficiently to the next generation by using an annuity to fund the purchase of a life insurance policy.
Many clients do accumulate wealth with deferred annuities. Often, though, they do not need these annuities to provide retirement income. Instead, many choose to pass these unneeded assets to their heirs.
Unfortunately, these deferred annuities are subject to a significant income tax, and in some cases, estate taxes, at death.
For example, a beneficiary in a 35% income tax bracket with a $500,000 annuity and a cost basis of $300,000 would be subject to $70,000 in income taxes at death. Only $430,000 would be available to pass on. Estate taxes could reduce that amount further.
However, annuitizing the same annuity over the owners lifetime could prevent this. The distributions from the annuity, which the man still owns, could be used to pay premiums on a life insurance policy owned by an irrevocable life insurance trust. When the annuity owner dies, no part of the annuity is included in his estate and the life insurance proceeds are received by the trust free from income and estate taxes.
Using the example above, suppose a 65-year-old male annuitizes his $500,000 annuity over his lifetime. In a 35% income tax bracket and with a projected 5% rate of return on the annuity, the yearly after-tax annuity payment would be $30,081 until age 87, the year of his life expectancy. The after-tax payment would then drop to $24,831 per year until he dies. (This reduced yearly amount reflects the fact that the exclusion ratio no longer applies.)
