When the goals are maximizing wealth transfer and minimizing tax exposure, the situation may call for a pairing of permanent life insurance with an annuity.
Not too long ago, an 82-year-old client walked into advisor David W. Hoffmann’s office with wealth transfer on his mind. “He told me he wanted to pass on as much money to his heirs as he possibly could,” recalls Hoffman, a Certified Financial Planner for D.B. Root & Co. in Pittsburgh.
Some time later the elderly client departed Hoffmann’s office satisfied, having committed, at his advisor’s suggestion, to purchase a life-only, single-premium immediate annuity in tandem with a permanent life insurance policy as a means of maximizing the wealth transfer potential of his estate.
People like annuities because they can grow their assets on a tax-deferred basis. But eventually the tax tab will come due – whether through annuitization or in a wealth transfer context – when the annuity contract passes on to beneficiaries. Then it may be time to consider pairing permanent life insurance with an annuity. For advisors and estate planners with senior clients, purchasing permanent life insurance along with an annuity is a relatively common maneuver, not only to use the tax-favored life insurance death benefit to maximize wealth transfer potential but also to blunt the impact of the estate tax and income tax double whammy that beneficiaries could face by inheriting an annuity that carries a sizable capital gains liability.
In the case of Hoffmann’s 82-year-old client, the payments from the single-premium immediate annuity went directly to cover the premiums on a universal life policy with a guaranteed death benefit. And since the SPIA payments were greater than the premium the client otherwise would have been able to afford, a simple crunching of numbers indicated the client would be able to leverage the annuity to access a UL policy with a larger death benefit – about 10 percent larger, Hoffmann says. Running the numbers also showed that buying a SPIA and a UL contract would be more cost-effective than purchasing a single-premium life insurance policy, another option Hoffmann and his client considered pursuing.
The client’s good health and single-minded drive to preserve as much of his estate as possible for his heirs made the entire dual-sided transaction straightforward – a “pure wealth transfer” maneuver, he explains. “It wasn’t anything fancy. We shopped around to find as much life insurance as we possibly could. We tried to maximize the death benefit and keep the cash value at a minimum. Cash value didn’t really matter. Then on the annuity side, we just shopped around to get the maximum payout, with a product from a good, quality company of course – one rated A or better.”
The client opted for a life-only SPIA, Hoffmann adds, because the annuity will not be considered part of his estate when he dies since payments from the contract terminate at death. Also, he didn’t need the tax-deferred growth offered by other kinds of annuities. This was an annuity purchased specifically to generate immediate income for a single purpose: to fund a life insurance policy configured solely to emphasize death benefit. Using proceeds from an immediate annuity to pay premiums automatically on a life policy appeals to many seniors, Hoffman notes, because it’s virtually hassle-free. No need to send a premium check every month to the insurance company.Dodge a double whammyPurchasing life insurance in tandem with an immediate annuity may require significant cash reserves, so it’s not a maneuver that typically works for seniors with cash-flow challenges. However, for clients with plenty of cash on hand and an estate that’s bound to burden heirs with a hefty income tax and estate tax tab, it can be a shrewd move, says Vern C. Hayden, CFP, who heads Hayden Financial Group in Westport, Conn. “It’s a way to cover the projected increase in value, or basis, with an annuity.”
“It’s for a more affluent client,” echoes Hap Patz, who heads Financial Advisors Inc. in Englewood, Colo., “who is willing to cover tax liability with the additional expense of a life insurance policy. Clients of more modest means usually will balk at that additional expense.”
However, faced with the intimidating prospect of an annuity whose growth will generate both income tax and estate tax exposure for beneficiaries, clients for whom wealth transfer is a top priority and cash flow isn’t an issue often find permanent life insurance an attractive option for defraying some of that exposure.
“An annuity can be double-taxed when its owner dies,” explains Benjamin A. Tobias, CFP, principal at Tobias Financial Advisors in Plantation, Fla. “The beneficiary may have to pay the gains [from the annuity over the lifetime of the contract] and the value of the annuity is included as part of the estate, so it’s exposed to estate taxes. That may not matter to some people, but for some, it’s a big problem, in which case purchasing an insurance policy can make a lot of sense. I’m not saying it’s for everybody, because if you sat down and factored in all the costs, the investment in both products may not be worth the money. But there are situations where it can make sense.”In insurance we trustEither UL or whole life can work in tandem with an annuity. UL policies tend to provide better value than whole life policies for the purposes of generating as much death benefit as possible, though some advisors, Tobias included, favor the bedrock certainty of whole life products. With UL, advisors tend to prefer insurance policies that come with a no-lapse guarantee to age 100, or even age 120.
Often, the life insurance component of the dual purchase, be it a whole life or universal life policy, resides in a trust outside the estate – typically an irrevocable life insurance trust in which the policy is owned by the trust. According to Patz, if the annuity is jointly owned, using a survivorship (second-to-die) UL policy can be the best route. When the second person named on the policy dies, the death benefit from the policy helps beneficiaries cover estate taxes without depleting the estate.In some instances, cash from an existing insurance policy (or from other accounts) can be gifted to the ILIT, then used by the trust to purchase a second-to-die single-premium life insurance policy. Such a maneuver removes that money from the estate; later, the tax-favored death benefit from the policy will go to cover estate taxes. With certain clients, advisors say, it’s wise to use qualified assets to purchase an annuity, then use the annuity payments to fund premiums on the life insurance policy. Here the advisor must determine the benefits associated with liquidating qualified assets versus any penalties associated with selling those assets prior to age 701/2 (if the client hasn’t reached that age).
Advisors who aren’t well versed in that type of maneuver, or in the potentially symbiotic relationship between an annuity and a permanent life insurance product in a wealth transfer and estate planning context, are wise to consult a tax specialist with a firm grasp of the process and its potential benefits. After a little handholding, it’s a maneuver that could become second nature.