If you are trying to create a death benefit for a client who is uninsurable, one key thing to remember is this: A deferred annuity is not life insurance.

This matters for tax purposes because Section 101 of the Internal Revenue Code taxes the death benefit of a contract qualifying as life insurance (under Section 7702) differently from the way it taxes the death benefit from a contract qualifying as an annuity (under Section 72).

The two chief differences are:

1.   All gain—or excess of contract value over adjusted basis—in an annuity will be taxed as Ordinary Income, either to the living contract holder or to the beneficiary. By contrast, the death benefit of a life insurance policy is generally received income-tax-free by the beneficiary.

2.   Distributions to the living owner of a life insurance policy are generally taxed under a first-in, first-out basis. All distributions are considered a return of principal until all contract gain has been distributed. On the other hand, distributions from an annuity (issued since 8/13/82) are taxed as gains-first to the extent of any gain (sometimes referred to as a last-in, first-out basis). This same treatment also applies to life insurance policies that are modified endowment contracts.

(Related: Understanding Deferred Variable Annuities’ Two Phases)   

A variable deferred annuity sometimes includes enhanced death benefit features that can provide a death benefit in excess of the contract’s cash value, whereas the death benefit of most fixed deferred annuities is limited to the cash value. The advantage of this additional death benefit in a variable annuity can be significant, especially for an individual who cannot obtain life insurance, or for whom the rates would be unacceptably high, for one simple reason: while the contract owner does not escape taxation on the death benefit of an annuity, he or she does escape insurance underwriting.

The annuity death benefit is available to anyone who is willing to pay the standard annuity costs charged for it (either as a part of the Mortality & Expense charge, or with a separate additional enhanced death benefit charge).

Tangle (Image: Allison Bell/TA)

(Image: Allison Bell/TA)

 

How large might that benefit be? Some variable annuities offer an enhanced death benefit that pays the greatest of:

  • (a) the contract value at death;

  • (b) total contributions, accumulated at a specified rate of interest (often 6 percent) until a maximum age (which is sometimes as late as age ninety-one), sometimes called the “rollup value”; or

  • (c) the contract value as of the highest annual, monthly, or even daily, valuation date, prior to some maximum age.

If investment performance of the annuity is good, the resulting death benefit can be far greater than the amount invested, or the cash value otherwise available at the individual’s death. Even if performance is poor, the second of those two factors produces a constantly rising floor under the contract death benefit.

Many advisors recommend variable annuities with enhanced death benefit guarantees for this reason. Yet even this strategy might be improved by splitting the annuity investment into more than one annuity contract, as can be seen from the following examples:

Example 1: Ms. A invests $100,000 in a single variable deferred annuity with an enhanced death benefit. She selects a diversified asset allocation model, consisting of 50% equities and 50% bonds. At Ms. A’s death six years later, the account balance is larger than at any prior valuation date, and is also larger than her contribution of $100,000, compounded at 6% — despite the fact that in the two years prior to her death, the stock market dropped significantly, while the bond market flourished. Her beneficiaries will receive the date-of-death account balance as a death benefit.

Dollar puzzle (Image: Thinkstock)

(Image: Thinkstock)

That balance includes the appreciated value of those subaccounts that did well (the bonds), and the value of those equity subaccounts that lost money. The losses of the latter are netted against the gains of the former to produce the total account balance.

Example 2: Mr. B splits his $100,000 into $50,000 contributions for each of two different variable deferred annuities, each with the same enhanced death benefit. He also allocates his overall annuity holdings in a 50% equities/50% bond mix. He allocates all the equities to the first $50,000 annuity, and all the bonds to the second.

At his death, the account balance of the first contract is lower than at a prior valuation date — due to the decline in the stock market — so the greater prior value is paid as a death benefit. The date-of-death balance of the second contract — containing the bonds that did well — becomes the death benefit of the second contract.

The losses in the first contract are not netted against the gains in the second. Indeed, the losses in the first are ignored, because the rollup death benefit value is used. Thus, Mr. B’s heirs receive more money at Mr. B’s death in this example because they receive all of the appreciation from the contract holding bonds and the rollup death benefit of the contract holding equities.

Sadly, many advisors are unaware of this strategy. Some even insist that an advisor’s sale of two annuities instead of one is inherently bad. Often, this is because they believe it results in a higher commission, which it does not.

— Read A Heretical Proposal: How About Sharing Risk With Our Annuity Carriers? on ThinkAdvisor.


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