Annuity Maximization

Josep M RovirosaWith the explosion of annuity sales over the past 10-15 years, it is not unusual at all to work with a client these days who has an annuity, sometimes a large one, in their estate. Because of the tax deferred nature of annuities, they can often grow quite large as they can be an excellent wealth accumulation vehicle. Unfortunately with the tax law being what it is, however, annuities are probably not the most tax efficient wealth transfer vehicle.

Why is that? Because annuities, like any tax deferred asset such as an IRA or other qualified plan, are double taxed at death. Because the annuity has grown tax deferred, when the client passes away, that growth is now subject to income tax-at the heir’s income tax rate! What’s more, the annuity is also hit with estate tax (assuming the overall estate will be).

So it is quite common to see a combined double tax rate of over 70% on the annuity! Yes, technically, there is a small credit for the IRD tax paid, but the bottom line is the client held a double taxed asset at death. And that’s why annuities may not be the most efficient wealth transfer vehicle.

So how can a client address or solve this problem? It is actually quite simple. The client starts by either taking annual distributions (preferably post 59 ½), or annuitizing the annuity. By doing the latter, one could actually remove the annuity’s value from the estate, saving estate taxes if it’s annuitized properly.

Once, the distribution is received, then the net proceeds are gifted to a life insurance policy held inside an Irrevocable Life Insurance Trust (ILIT). Now those dollars are outside the estate and the client has achieved major leverage on those dollars via the life insurance proceeds. Now far more net proceeds will be passed to the heirs versus the approach of simply doing nothing & letting the annuity continue to grow inside one’s taxable estate.

So it is as simple as moving the asset from the “double taxed” bucket to the “tax free” bucket, i.e. from the annuity to the ILIT. Because the insurance is held in a trust outside the estate, estate taxes are NOT assessed on the insurance proceeds. And because the trust asset is insurance, there is no income tax on the proceeds at death either. And because of the leveraged dollar effect by using life insurance, the heirs receive more.

Bottom line: 83% of annuity holders never using their annuity for income purposes (Forbes, 2002). So as clients begin to think in terms of wealth transfer, the annuity should be one of the first assets considered for repositioning. Otherwise, they will hold a double taxed asset at death, of which only approximately 30% will pass to the heirs. Annuity Max can solve this potentially large problem.

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