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Leverage Your Clients' Giving Through Annuities and Life Insurance

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From the tsunami of 2004 to the hurricanes of 2005, Americans have been exposed not only to devastation and heartbreak, but also to an outpouring of support for those in need. According to the Giving USA Foundation, individuals gave $187.9 billion to charities in 2004, up more than an estimated 4.1% over 2003. And while the tsunami in the Indian Ocean brought much attention to charitable giving, the giving it generated represented a small fraction of all charitable gifts.

Financial professionals are in a great position to help their clients do more through financial planning and charitable giving. In a study done a few years ago, 98.8% of philanthropic/affluent individuals said they wish they could do more for charitable organizations. The three main reasons for not doing more were: (1) They believed their current financial situation limited their efforts; (2) they worried about giving’s impact on their future finances; and (3) they didn’t know how to give more effectively.

Clearly, the assistance of a qualified financial professional can help these individuals unlock the potential they have to give. One of the most under-utilized tools many individuals hold is the nonqualified annuity.

Nonqualified annuities are primarily purchased to help build retirement assets in a tax-deferred manner. However, while the intention may be to use these dollars in retirement, very few annuity holders annuitize these contracts. And most are left with a significant remaining balance upon death, leaving the proceeds and the tax bill to the kids and grandkids. For those that have a desire to leave money to their heirs and a desire to help their favorite charitable cause, there may be a better way.

An alternative solution

Let’s look at an example. Dixie is a 60-year-old female in good health. In completing the financial analysis you uncover her desire to pass wealth to her kids. If possible, she would like to give more to her favorite charity, but not at the expense of leaving less to her kids.

Dixie has the financial resources to maintain her current standard of living without having to invade principal. And her former employer has provided good medical coverage that will last through retirement. She just recently purchased long term care insurance.

Among her financial assets is a nonqualified annuity contract worth $272,271 with a cost-basis of $159,551. Although Dixie’s current estate would not be subject to federal estate taxes, a significant portion of the annuity contract would be lost to income taxes upon distribution.

To preserve the present value of the annuity, and to enable substantial gifts to her favorite charity, you propose annuitizing the annuity over a 10-year period certain. This provides an income stream of $32,986 per year, of which $15,965 is considered an income tax-free return of principal.

Dixie uses the $15,965 as a premium payment on a $375,000 life insurance policy covering her own life. Dixie is listed as the owner and insured; her children are listed as the beneficiaries. The remaining $17,021 of each annuity payment is considered the taxable portion. This amount is then gifted to a charitable foundation, giving her a current income tax deduction that offsets the taxes owed on each annuity payment. The charitable foundation can use these proceeds as it sees fit.

To gain even more leverage from the situation above, Dixie could purchase a $425,000 life insurance policy on her own life and then assign ownership to the charitable foundation. The foundation can use the annual gifts it receives from Dixie as the premium payment for the life insurance contract.

When all is finished, Dixie will be able to make a sizeable gift to her favorite charity, preserve an inheritance for her children, and eliminate the tax liability on the annuity by itemizing the charitable gifts on her tax return.

Important notes on this strategy

In this example, we annuitized the annuity over a 10-year period certain. At Dixie’s current age, this provides a substantial annual payout necessary to fund the life insurance. If death were to occur during the first 10 years, the remaining payouts could be left to her heirs in addition to the life insurance proceeds.

Depending on the client’s age, estate value and risk tolerance, other annuitization schedules, including a life-only annuitization schedule, may be appropriate. Keep in mind that annuity contracts annuitized in the early years may be subject to surrender charges and/or other fees. They may also be subject to a 10% premature distribution penalty tax if annuitizing prior to age 59 1/2 .

In our example we used a universal life insurance contract illustrated to endow at age 100 based on current interest rates and the cost of insurance. It is important to note that the contract is not considered paid-up after 10 years; and the death benefit is not guaranteed to age 100.

The use of a secondary guaranteed UL contract may provide a larger initial death benefit and longer guarantees with less cash value growth potential. We also assumed a standard non-tobacco classification for this contract. In some cases, a substandard rating could make the premiums much higher and the strategy inappropriate. You should determine the client’s qualification for life insurance before implementing this strategy.

Had Dixie been married, the use of a second-to-die contract may have provided even greater leverage to both the children and charity, with death benefits paid at the second death.

In situations involving larger taxable estates, third party ownership of the life insurance contract outside of the insured’s estate may be appropriate. As always, it is important to involve the client’s tax advisor and accountant before implementing this strategy. In addition, whenever possible, include the client’s children in the discussion.

As we work with clients and prospects, let’s not forget to uncover charitable “wishes.” You may be surprised how many individuals would like to do more and are just looking to you for answers.


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