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You Can’t Take It With You

Leaving behind an annuity could result in financial woes for your heirs. Here's how to manage your estate for the best possible outcome.

By Michael Vaughan

Tuesday, September 25, 2007

The above title is perhaps the most nuanced way to say what almost all insurance agents and financial planners already know: You don't want to die with an annuity.

Principally, there are two reasons for this. First, the stable payments that an annuity provides-while perfectly tailored to the finances of the original annuity owner-rarely fit so neatly into the financial goals and objectives of heirs and beneficiaries. For instance, $528 a month is a nice supplement to Social Security and pension income. But if you've got a kid going to a private, four-year college, $528 is, literally, chump change.

The second reason that you don't want to leave an annuity behind or have one left to you is taxes. Specifically, the tax treatment of annuities is Draconian to say the least. Because of this, tax-wise, they are probably the least efficient way to transfer wealth from one generation to the next. Now, it's important to keep in mind that we are not tax advisors, and we are not offering any tax advice in this article. But through generalized examples, we hope to bring to light the notion that annuities, taxes, and wealth transfer may merit review and action on your part.

And make no mistake about it. The concept of wealth transfer is taking on more importance as Boomers pass on the staggering wealth they created. By some calculations, the largest wealth transfer in history will occur between now and 2041, when an estimated $41 trillion changes hands.

Inherited annuity = high taxes
The problem is that when an annuity changes hands via an inheritance, one of those hands belongs to the government, and it reaches very deep into the pockets of the estate. For example, if your estate is above the $2 million exclusion from federal and state estate taxes, when annuities, as well as other investments, pass from you to your heirs, they will be taxed at a top rate of 45%.

And unlike other investments, many annuities have an additional tax wrinkle: any gains that have accrued in annuities will be taxed at the beneficiaries' ordinary income tax rate at the time of payout from the annuity. Thus, even if your estate is below the $2 million threshold, the tax on gains inside your annuity still applies, which at a top personal rate of 35%, can be significant. Therefore, an annuity with $200,000 of gains inside of it could still provoke ordinary income taxes of $70,000 to your heirs.

A solution: optimize tax efficiency
But some estate planning done in advance can blunt the tax impact. Mind you, the ‘no such thing as a free lunch' concept applies when it comes to reducing the tax bite of inherited annuities. Nonetheless, tax efficiency can be optimized, and because we are often talking about a lifetime of wealth accumulation, this optimization can be meaningful. Below is a case study of how one individual used the secondary market for annuities to re-arrange his assets in such a way as to put his heir ahead by $1.3 million.

"Earle" owned an annuity that provided him with 20 years of guaranteed monthly payments, in addition to other investments valued at about $2 million. Four years after buying the annuity, it had a "present value" of $1.1 million. Earle knew that if he died at that moment, his daughter "Jeannie" would owe estate transfer taxes equivalent to 45 percent of the $1.1 million value of the annuity. Yes, she would get the income it generated-$7,865 a month for the next 16 years-but that paled in comparison to the almost $500,000 ($1.1 million x 45%) in estate transfer taxes Jeannie would have to pay. Ultimately, Jeannie would probably have to sell other investments just to pay the estate taxes.

In an effort to plan for a more efficient transfer of his wealth, Earle took the first step toward re-aligning his assets to reduce the overall tax burden on his estate. In general his strategy rested with moving assets from taxable annuities into non- taxable life insurance products.

To do this, Earle sold $4,000 of the $7,865 he received per month for the remaining 16 years of his guaranteed annuity payout period. Through this sale, he raised a total of $449,000 and used it to fund a life insurance policy with a face value of $1.6 million, which was established as an irrevocable trust.

As a result of the sale, Earle received $3,865 ($7,865 - $4,000) of his regular monthly payments and would continue to do so for the next 16 years. But if he died today, his daughter would inherit $1.6 million tax-free in the form of a death benefit from the insurance policy, plus the remaining value of the annuity, which was approximately $300,000 ($525,000 of annuity net present value after the partial sale - 45% estate transfer tax = $289,000) for a total of approximately $1.9 million.

The net effect of Earle's strategy was significant in terms of the impact on his daughter. Specifically, the $1.9 million Jeannie would inherit net of taxes (which is above and beyond the $2 million of Earle's estate which fell under the federal state tax exemption) is $1.3 million greater than if Earle had done nothing at all. That is, passing on the $1.1 million annuity wholesale and leaving Jeannie to pay the $495,000 in taxes on it, would have resulted net after tax proceeds to his daughter of just $600,000.

But thinking about the difference, not just in the present value of what Jeannie would inherit if Earle died immediately, but in terms of the future, the net impact of Earle's planning is more significant. For instance, if the $1.9 million is invested in stocks, bonds, and mutual funds over the next 10 years and earns an average return of 7%, it would grow to $3.7 million. By comparison, under the original scenario, the $600,000 would grow to just $1.2 million. Ultimately, the impact of Earle's planning could result in a $2.5 million windfall for his daughter Jeannie.

New possibilities for annuities
What makes this kind of planning possible in ways that heretofore were not available is a growing secondary market for annuities. These once illiquid investments can now, in many cases, be resold, and this is opening up new opportunities for annuity owners as well as heirs to have a positive impact on the wealth transfer challenges that annuities present.

And despite these benefits, some cautionary notes are still in order. The first of these, under the no free lunch banner, is that in the previous case, note Earle sold 51% of his monthly payments. It's important to remember that annuities are purchased to provide a stable source of income, and not everyone can so easily and blithely sell off a portion of the security they perhaps just recently purchased.

Second, annuities can be complex financial instruments; there may be all manner of bells and whistles on them that can preclude an easy sale and the level of tax avoidance described in this article.

And while prudence should be exercised in the sale of an annuity, annuity owners and their heirs need not exercise such caution in exploring the options now available to them to optimize their wealth and reduce their estate taxes.

Disclaimer: Obviously every situation is unique, so please don't take this as tax advice. You should consult a tax professional regarding your personal situation and how the secondary market for annuities can help you with your estate planning.

-Michael Vaughan is the managing director of J.G. Wentworth's Annuity Purchase Program^TM. Mr. Vaughan has been a featured guest on The Wall Street Journal - This Morning, in addition to several other national and local radio programs. Mr. Vaughan has written articles for many top trade publications to educate insurance and financial professionals, in addition to being quoted as a leading industry expert in Time Magazine, Business Week, MarketWatch, Annuity Market News, Investors News, Dow Jones Newswires and the personal finance column of many of the country's largest newspapers.

For more than 15 years, J.G. Wentworth has been purchasing annuities and structured settlements from individuals. During this time, the company has paid out more than $2 billion in cash to clients for the purchase of future payment obligations. The company's annuity-backed notes are AAA by Standard & Poor's and Aaa by Moody's. Contact J.G. Wentworth toll-free at 800-535-0195 or Mr. Vaughan directly at 484-434-2387 or mvaughan [at] JGWentworth [dot] com.

 

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