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Annuities and life insurance: Mix and match

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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.”

Do not, repeat not , put the horse before the cart. “I would never recommend annuitization until I know that 82-year-old client could get insurance,” Smith advises, “because once you annuitize, it’s done.”

Know how to stretch

Now we can move on to the legacy planning, on both the non-qualified and IRA, side of the picture. Here we find the “non-qualified stretch,” and the “multi-generational stretch IRA.” The stretch has been around since the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001), and many financial advisors know it well. But not all.

“The problem is a lot of advisors out there are not trained and they don’t know how to do it. So they may not even be advising the (stretch),” Smith says.

Enthusiastic practitioners agree that the stretch is a powerful tool for the client seeking wealth preservation with tax reduction that ought to be understood and put into action by more financial advisors.

The multi-generational stretch begins with the advisor checking to make sure that the annuity provider offers and supports the ability to do a “restricted beneficiary payout,” which permits the non-qualified stretch. Many carriers don’t.

When the advisor sets up a “non-qualified stretch,” the annuity’s income tax liability can be stretched over the life expectancy of the beneficiaries or, for that matter, the remaining lifetime of the annuity owner.

“Most of the time we have a younger beneficiary, who has a much longer life expectancy,” Smith says. “So we can allow those dollars to continue to earn interest and not pay all the tax when the (annuity owner) dies. [It's] very powerful.”

Say the beneficiary is 50 years old, and has a life expectancy to about age 83, or another 33 years. The 50-year-old inherits $100,000 of taxable income, but has set up a non-qualified stretch. Due to a little bit of tax code magic called the exclusion ratio, the 50-year-old inheritor can spread the tax payments over the 33-year period, allowing the money to continue to grow.

Or say the beneficiary is your 6-year-old granddaughter, who has a life expectancy of 80-some years. Little Sally can pay 1/80th of her tax liability annually.

Nor, if the stretch is properly set up, does the money have to be re-annuitized by the heir(s) in order to take advantage of the exclusion ratio.

“What you have to know is that the exclusion ratio depends on the ratio of gain in the contract,” says Smith. “So if you put in $100,000 and now it’s worth $200,000, 50 percent of it has already had the taxes paid on it. So the exclusion ratio in the non-qualified stretch says that we cannot annuitize and can still exclude 50 percent of it from taxation. [That's] huge.”

Another benefit of the multi-generational stretch is that the owner gets to restrict the younger beneficiaries to the required minimum distribution, if so desired, and not use a trust to do it. “That also is powerful,” Smith says.

The price is right

Yet another major advantage of the stretch is that it is free.

“To me, the no-brainer is the non-qualified stretch. That’s free, while you have to qualify for the life insurance” in our earlier example, Smith says. “Assuming that the client isn’t spending any of their interest, all they’re doing is allowing their money to work harder. It’s matter of structuring their portfolio.

“This is how the very wealthy people in this country continue to pass wealth from one generation to the next, and they don’t lose dollars to taxes.”

Smith is not the only adviser evangelizing for the stretch. But, again, it all depends on whether we’re taking about qualified or non-qualified dollars.

“The stretch option, absolutely, is the only option through which an IRA should be passed down to the beneficiaries. It is powerful,” says Grubb. “But not everybody has an IRA, and they really should be looking at using the insurance, absolutely, because a lot of people have non-qualified money – money that they pay taxes on.”

David Lewis is the founder and owner of Monegenix. He designs insurance-based financial plans, financial calculators and apps for business owners and professionals. For more information, please visit


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