With interest rates at historically low levels, certain types of fixed interest rate financial assets may prove to be inefficient conduits for the transfer of wealth to heirs. These fixed assets include CDs, money markets, corporate bond funds and U.S. government securities. Yields on these investment instruments have declined dramatically, thus leading to shrinking levels of income for those who hold them. The current yields on these types of assets are also taxable for income tax purposes.
The question to ask is, “Can a client use an ‘asset repositioning’ strategy to provide an increased income stream while transferring an equal or greater asset value to heirs?”
The answer is yes. By transferring a low income yielding asset to a tax-efficient Single Premium Immediate Annuity (SPIA), the client can obtain a potentially higher guaranteed life income. By definition, a SPIA is the liquidation of both principal and interest over a life expectancy. This non-qualified SPIA will have an “exclusion ratio” where a large part of each annual guaranteed payment will be tax free and a small part of each annual payment will be taxable.
The part of the SPIA income not needed for current spending could be used to purchase a life insurance policy where cash values grow tax deferred and the death benefit is income tax free. The policy could be owned personally by the client or owned by an Irrevocable Life Insurance Trust (ILIT) created by the client. This plan could result in an increased amount inherited by the heirs when compared to the non-leveraged and taxable yields of the other fixed financial tools described earlier.
The client is a 70-year-old widow and has been receiving Social Security retirement benefits. She has $300,000 of mutual funds allocated between corporate bonds and U.S. government securities with a current average yield of 3 percent. The client is in a 20 percent federal/state tax bracket and has seen her annual income from this yield decline from about $18,000 ($14,400 after-tax) in 2008 to only about $9,000 ($7,200 after-tax) in 2012. Her plan is to spend this after-tax annual yield and leave the current principal of $300,000 to her two adult children. Is there a way this client can increase her income back to her 2008 level while still providing an inheritance to her heirs?