Annuities and life insurance: Mix and match

Traditionally, life insurance is a product that protects you from dying too soon and annuities are products that protect you from living too long. Why would an advisor ever wish to put the twain together?

The answer is that annuities can grow money into even more money, on a tax-deferred basis. But when taxes no longer are deferred the income is due at marginal income tax rates, either for the policy owner or his or her heirs.

Can packaging life insurance with an annuity help preserve wealth and pass it along to beneficiaries? Oh, yes.

“Life insurance and annuities obviously can go hand in hand – the life insurance can be the saving grace, especially either if it is a qualifying plan, which means it’s 100-percent taxable to whoever takes the money out, or an unqualified plan that is going to contribute to an estate tax problem,” says Carol Ward, a Stockton, Calif.-based CSA.

Then there is the non-insurance, not-necessarily-an-annuity side of the story, the multi-generational stretch, which we’ll get to in a moment, and which some experts say is the cat’s pajamas for clients with IRAs.

If you haven’t added these tools to your repertoire, you and your clients could be losing out.

“My partner and I went over a case this morning. He’s in the conference room with a client right now,” laughs William A. Smith, president of Sandusky, Ohio-based Great Lakes Retirement Group Inc. “The client comes in and has money in annuities. It’s a pretty good portfolio. I can’t recommend the client replace those annuities, but he has a huge tax liability that got overlooked. So we can really help him out by putting an estate plan together, and a plan in which we can minimize taxation, if that is important to him or his heirs.”

Find the proper solution

The key to understanding this life equation is two-fold. Step No. 1 means first understanding the big picture of why your client wants to and/or should seek an insurance-related annuities solution. Smith calls first taking the top-down view “a holistic approach.”

This is particularly true because at the root of the annuities-life insurance combination is the client’s estate. And when it comes to estate planning, a bad misstep can turn out to be … very bad indeed.

And, because often it is an older client in need of this combination of tax, estate and investment planning, a wrong step also can end up inflaming the wrong people.

“Find out what is most important to that man or woman. All too many times we find folks in the industry who just want to sell a life policy, Smith says. “If I go making an 82-year-old the owner of a life policy for $200,000, and I cause a federal estate tax problem because I made that 82-year-old own that policy, and an attorney gets hold of that, look out.”

Now that you’ve been cautioned, we’ll look at step No. 2, sorting out the assets with which the client will finance the solution. Qualified money and non-qualified money take distinctly different paths toward the goals of wealth preservation, tax reduction and, usually, passing along what is left to one or more beneficiaries.

The non-qualified, non-IRA side also breaks down into two ways to reduce income tax liability with the aid of a life policy. One method is fairly common and one less so.

The best-known technique is to pair the annuity with a universal life policy. The less well-known way is to match an annuity with a death benefit rider. We’ll start with the annuity-universal life tandem. How are they put together to accomplish the client’s goals?

Jay Grubb, president of Buford, Ga.-based Key Financial Partners, describes the method he calls “back-figuring.” Let’s say a 60-year-old client plans to put $100,000 into an annuity for the primary purpose of transferring it to his wife and other beneficiaries. Grubb takes the client’s life expectancy, in this case age 82, which means his annuity might well have 20-plus years of growth left in it. So what the advisor does is back-figure what kind of life insurance is required to cover the client’s needs. But, because there is no way to know the annuity’s future tax gains, Key Financial might take 20 percent of the $100,000 and put it in a single premium immediate annuity and calculate how much income the SPIA will generate. And, thus, how much insurance it will buy.

Advisors choose universal life over term for a simple reason. “You don’t know how long the client is going to live,” Grubb notes. “He could live to 100.”

But some people’s health or other factors – such as the swelling cost of life insurance as the buyer grows older – won’t let them qualify for a life policy.

Another scenario for the client’s annuity is to add a death benefit rider that pays the client’s income tax bill, leaving his or her heirs in the clear. (An advantage to the death benefit rider is that there is no underwriting for the client.)

In the case of a $50,000 gain, upon the client’s death the beneficiaries would receive a check for the account value of the annuity from the life insurance company, plus 28 percent of that gain to cover the tax; an annual expense charge paid out of the annuity covers the tax payment.

Grubb says another option for a client with health conditions is choosing a Simplified Issue Policy. It costs more, but has the benefit of a “very liberal process which has few questions underwriting it.”