An Annuity-Based Estate Plan

Successful estate planning will transfer clients’ assets to heirs and beneficiaries quickly, with minimal tax liability. In this article, we take a closer look at some tax implications and the benefits of simple, transparent, no-commission products that cut costs and offer more investment options. In a later article, we will examine the advantages of using variable annuities (VAs) for greater accumulation, as well as the benefits of using VAs with certain types of trusts. (Do note that variable annuities involve risk, including possible loss of principal.)

Of course, VAs are not the only tool for estate planning and, in some cases, life insurance may be a more effective vehicle for the transfer of wealth. Also, keep in mind that clients may benefit from consulting with an estate planning expert or tax-planning expert to develop an effective strategy for leaving a lasting legacy. This is especially true for your high-net-worth clients.

Taking on taxes

When it comes to estate planning, many advisors and investors will question the tax treatment of variable annuities. When gains on variable annuities are withdrawn, they are taxed at ordinary income tax rates, as opposed to the lower long-term capital gains tax rate typically paid on other investments, such as equities and mutual funds. However, the benefit of tax-deferred compounding over years or decades can help alleviate this–especially when a low-cost VA is used.

Likewise, many advisors and investors may be concerned that, in addition to federal estate taxes, beneficiaries will also be subject to tax on Income in Respect of a Decedent (IRD) if a VA is included in an estate. Still, there are several reasons that an annuity may prove beneficial to your client.

First, when working with a non-qualified VA that is funded with after-tax dollars, the portion of the annuity referred to as the “cost basis” is excluded from IRD. Because this cost basis portion of a non-qualified annuity, which is the sum of the total contributions to the VA, has already been subject to income tax before it was contributed, it will not be subject to income taxes a second time. The cost basis does not create IRD upon the owner’s death. Only the gains in excess of the cost basis at the time of the owner’s death will create IRD when distributed. (Note that if the VA is purchased with qualified money, contributions have not been subject to tax.)

It is possible that the owner’s estate may be liable for estate taxes on the entire account value, not just the earnings. But, in this case, should the owner’s estate pay any federal estate taxes attributable to annuity earnings, this will also be deductable against IRD for federal income taxes owed by the beneficiary (for details, see IRS Pub 559, page 12).

In addition, it may be an advantage if the marginal income tax rate of the beneficiary is lower than that of the original annuity owner. By replacing taxable income to the original owner in a higher bracket with IRD to his or her heir in a lower bracket, it may actually result in less federal income tax paid, rather than more. This is similar to the benefits enjoyed by an annuity investor who makes contributions while their marginal income tax is relatively high, but takes distributions when their rate is relatively low.

Finally, to help ensure that a beneficiary will be subject to a lower marginal income tax rate, it may be appropriate to take advantage of annuitization options or a withdrawal strategy. By distributing income from the annuity over the course of many years, a beneficiary may be able to avoid being pushed into a higher tax bracket by IRD. For example, a beneficiary may have the option, upon receipt of the VA, to annuitize and receive payments over their lifetime, or they may choose to withdraw the proceeds over a fixed period. And, of course, certain heirs such as spouses may choose to continue using the VA to defer taxes and take advantage of the benefits of compounding.