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Retirement Planning > Retirement Investing > Annuity Investing

When The Taxman Gets His Money

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There are many are great reasons to purchase deferred and immediate annuities, including tax deferral and the exclusion ratio. Still, the tax bill eventually comes due, so advisors need to provide clients with accurate details about potential tax liabilities, too. Here are some points to keep in mind.

Deferred annuities and estate taxes. When a deferred annuity owner dies before the annuity matures, the annuity’s cash value is included in his gross estate (IRC ?2039[a]). The annuity value could be subject to estate taxes if the deceased owner’s estate is large enough. If the annuity has a guaranteed death benefit, then the size of that benefit amount may affect what is included in the owner’s gross estate.

Example: Suppose a client has a variable annuity with a $100,000 guaranteed death benefit. If, when the owner dies, the VA’s cash value is $80,000, the insurance company will pay a $100,000 death benefit to the named beneficiary – and the estate must include the $100,000 death benefit in its gross estate (even though the VA cash value was only $80,000). If the cash value was greater than $100,000, however, and if the VA provided that the beneficiary receives the larger of the cash value or the guaranteed death benefit, then the VA’s cash value would be included in the deceased owner’s estate.

If a deferred annuity client does not expect to use the annuity funds during his life, then consider talking with him about a more efficient way to pass that wealth to heirs. If he holds the annuity until death, it will be included in the gross estate and may ultimately be subject to estate taxes. In addition, a portion of the death benefit may be taxable to the beneficiary as income.

A more efficient way of transferring the annuity value would be to create an income stream from the annuity, either via 1035 exchange into an immediate annuity or putting the deferred annuity into settlement. The income payments could then fund a life insurance policy. Upon the client’s death, the life policy proceeds would pass income tax-free to the beneficiary.

Immediate annuities and estate taxes. Assuming owner and annuitant are the same person, life only immediate annuities are payable for the owner’s lifetime and cannot be included in the estate because payments end at death. However, joint and survivor and period certain annuities can also have estate tax implications.

Example: Under a joint and survivor immediate annuity, when one joint annuitant dies, the value of the survivor’s annuity can be included in the deceased annuitant’s gross estate, to the extent of the deceased’s contribution toward the annuity purchase (IRC ?2039[a] and [b]). If the deceased did not contribute towards the annuity purchase, the remaining annuity value is not included in the gross estate. If the deceased paid for the entire annuity, then the entire remaining annuity value is included in the gross estate (at an amount equal to the insurer’s charge to the surviving annuitant for a lifetime annuity at time of the first death).

As a practical matter, many joint and survivor annuities are purchased by married couples. When one spouse dies, the annuity avoids estate taxation in both estates because of the unlimited marital deduction and because the annuity’s survivor portion ends at the second spouse’s death.

Similarly, an annuity with a guaranteed certain payout is also subject to potential estate taxes. If the annuitant does not live beyond the guaranteed period, then the remaining payments can be included in the deceased annuitant’s estate. The amount included in the estate is the present value of the remaining payments (IRC ?2039[a]).

Collateral assignment. Often, people use bank CDs or life insurance policies as collateral for a bank loan. But if the client has replaced CDs with a deferred annuity, the client may consider using the annuity as collateral instead. This may sound like a good idea but it will be nothing but trouble for the client. If a contract owner assigns or pledges any portion of annuity value as collateral on a loan, the assignment or pledge will be a taxable distribution from the annuity (IRC ?72[e][4]).

Most insurers have a form for the client to sign if they collaterally assign the contract. The form will indicate that such an act will result in a taxable distribution. The client may read the form and then ask for an interpretation, so be prepared to help the client understand the implications of pledging annuities as collateral on a loan.

Assigning annuity payments. The gifting of annuity payments from an immediate annuity to a third party has other issues. Example: Sue decides that she must help support her elderly mother, so she buys an immediate annuity and directs the insurer to deposit the payments in her mother’s checking account. This makes it easy for the mother to receive a check and do a budget.

However, a fundamental tax rule says income created by an asset is the responsibility of the asset owner. Thus, unless Sue transfers the annuity ownership, she is accountable for income taxes on the annuity. Also, each annuity payment represents a gift to the mother, so Sue could be liable for federal gift taxes.

Advisors who understand the tax rules for products they sell can help prevent clients from encountering unexpected tax problems. This knowledge will foster better product choices as well as help plan for future tax liabilities.


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