A New Wealth Transfer Strategy

For years, insurance companies have tried to develop a product that delivers the benefits of annuities and life insurance without the pitfalls. Annuities offer growth, but in the event of the owner’s death, that growth is subject to federal income taxes. Life insurance provides a federal income tax-free death benefit, but traditional policy expenses can mitigate growth of the account value.

Take an average variable annuity, for instance, which charges around 1.25% annually for mortality-and-expense risk. Consider adding a guaranteed minimum withdrawal benefit or an enhanced death benefit guarantee and you’re now approaching 2.4% in average annual fees.

To maximize income tax deferral, many annuity holders retain these products and pass away with their annuity investments untouched. They intend to leave these assets to heirs, who are then obligated to pay federal income tax on the earnings.

In this situation, the annuity balance can be significantly depleted by taxes before it is passed on. Annuities can be very useful tools for accumulating wealth and providing income, but inefficient vehicles for wealth transfer upon death. On the other hand, life insurance includes management fees and cost of insurance (COI) coverage — unnecessary burdens when the ultimate goal is accumulation.

Consider this scenario: Steve is a 65-year-old male with more than $7 million in assets. He has adequate income to maintain his current lifestyle and his main concern is passing money onto his heirs. He has $1 million in a money market account intended for his son and he is considering moving the money into a variable annuity or purchasing a traditional life insurance policy.

If he purchases a variable annuity, a gross account value of $1,275,000 after five years would leave a death benefit of only $1,178,750, assuming a 35% tax bracket for his son — that’s nearly $100,000 in federal income tax.

Should Steve choose the life insurance policy, the COI on his contract will increase as he gets older. If it is under-funded, the COI will begin to deplete Steve’s assets. It’s even a possibility his policy could run out of cash-value and lapse without benefit, unless he begins paying additional (and often times hefty) premiums into the policy. He could also purchase a “no-lapse rider” offered by many insurance companies, but would incur additional costs, lowering the growth of the account. This is a daunting situation, especially considering he believes his son’s inheritance is protected and would grow at a reasonable rate.

Numerous affluent investors like Steve face this same situation. In fact, 2005 marked the second consecutive year that U.S. millionaire households increased by 11%. Many of these aging clients have funds they intend to pass on to their children, grandchildren, other close family members, or religious and charitable organizations.

These individuals are increasingly overwhelmed with the task of directing numerous wealth managers. Ideally, products used by this high net worth group should provide privacy, control, flexibility, tax-favored investing and asset growth with financial protection for heirs.