While death and taxes are inevitable, there’s no sense enabling the two to conspire and compound the misery that they provoke. That is, saddened by your loss, heirs and beneficiaries will likely endure a second blow when they confront the taxes due on the investments which you left them. This is especially true if you own annuities, which are universally agreed to be the least tax efficient way to pass wealth from one generation to the next.
However, all is not lost. A little advance estate planning on your part combined with new flexibility with respect to selling annuities means that you can lower the impact of taxes and increase the wealth you pass onto heirs and beneficiaries.
Every little bit helps
Even modest improvements can have a large and meaningful impact on your children and grandchildren when you consider what can happen with tax deferred investing over their lifetime. That is, if you can pass on $50,000 through a little advance planning that would otherwise be paid in estate taxes to your 40 year old son, what might that be worth when he turns 65? Well, if he achieves a 7%, tax deferred return over the 25 year period the $50,000 you save from the clutches of the government will grow to more than $271,000.
So, your investment in time is well worth it. But where to start? The first step is to recognize the different kinds of tax liabilities that your annuities may provoke, which in turn has a lot to do with the kind of annuities that you own.
If you own an annuity, there is a strong likelihood that it’s a so-called deferred annuity that you are funding, but is not yet in payout. The challenge these instruments present is that they introduce taxes that few if any other investments do. Specifically, if you die with a deferred annuity not in payout, all of the gains inside of it become ordinary income to your heirs and beneficiaries.
For example, suppose you have a deferred annuity with $250,000 of gains inside of it. If you die, the entire $250,000 becomes ordinary income for your beneficiary. And demographics can compound the tax bite this provokes. If your beneficiary – other than your spouse – is in the peak earning years of their late 30s or early 40s, they may have to pay tax at the top personal rate of 35%. On a $250,000 gain this would be some $87,500 ($250,000 x 0.35) which may be equivalent to two years at a private college, or a down payment for a second home or a kitchen remodeling, and then some for a first home.
And get this: The tax on gains in deferred annuities is due even if your estate is below the (current) federal estate tax exclusion of $2 million. To understand just how Draconian this is, consider that tax treatment on a $500,000 portfolio of stocks, bonds and mutual funds with a basis of $250,000 and unrealized gains of $250,000 versus the tax bite on a deferred annuity with $250,000 of gains. Rather than a tax on the $250,000 gains in the stock, bond and mutual funds, these assets will pass to your beneficiary tax free. The only substantive change is that your beneficiary’s basis increases to $500,000 – a significant advantage. If he or she sells the entire portfolio several years later when the value reaches $800,000, a long term capital gains of 15% taxes are due on just $300,000 ($800,000 value - $500,000 basis of beneficiary), but the taxes on the $250,000 that was earned while the assets were in your estate are avoided forever.
If you don’t have a deferred annuity, there’s a good chance you own an immediate annuity—one which you fund up front for a lump sum of cash which immediately generates regular cash payments. The tax consequences of dying while an immediate annuity is in payout are not as onerous as the situation with deferred annuities. In this case the interest portion of each annuity payment—usually very small in comparison to the principal portion of the payment—will be taxable as ordinary income to your beneficiary.
Big money = big taxes
However, the situation changes dramatically if your estate is above the current $2 million estate tax exclusion. In this instance, the current estate tax rate of 45% may be applied to all of your assets—stocks, bonds, mutual funds and annuities—above the federal estate tax exclusion.
Therefore, let’s say you have $2 million of stocks, bonds, and mutual funds, and that you bought an immediate annuity for $1.58 million that would pay you $7,865 a month, guaranteed for 20 years, and thereafter, for as long as you lived. If you died after four years – when the annuity has a present value of $1.1 million – the tax on it could be $495,000. True, the beneficiary would begin to receive $7,865 each month, but this figure pales in comparison to the $495,000 of taxes owed.
In truth, once you are above the federal estate tax exclusion, currently $2 million, the 45% tax applies across the board and is onerous regardless of the composition of your portfolio: stocks, bonds, mutual funds or annuities.
Dividends ahead
However, estate planning can still deliver big dividends to your heirs and beneficiaries if you own an immediate annuity in payout. Specifically, the strategy rests with switching from insurance products that can carry a tax liability – annuities – into to products, that, if properly structured, do not – such as life insurance.
Taking the above example into account, what if instead of keeping the annuity and taking all of the income, you sell $4,000 of the $7,865 monthly income, for the remaining 16 years? By doing so, you can raise approximately $448,000 and use these proceeds to purchase a $1.6 million insurance policy that is placed in an irrevocable trust for your beneficiary. Now if you die right after purchasing the insurance policy, the beneficiary will receive the $1.6 million life insurance proceeds tax free plus the remainder of the annuity, worth approximately $300,000 after estate taxes.
Moving assets from annuities to life insurance increased the wealth transfer from $600,000 ($1.1 million annuity value at the time of death – $495,000 estate transfer tax) to $1.9 million ($1.6 million of insurance proceeds + $300,000 remaining annuity value net of estate taxes) for a net difference of $1.3 million.
Ultimately, what makes these gains in tax efficiency available is the rise of a secondary market for annuities. Now specialty finance firms such as ours, as well as our competitors, will buy annuities. Not too long ago, if you owned an annuity, you were stuck with it for life. But not anymore. Now you can sell your annuity, or pieces of it, to make sure that as your life changes, your annuity can keep pace with it in a way that generations to come will be thankful for.
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. He has been a featured guest on The Wall Street Journal—This Morning, in addition to several other national and local radio programs. He has also written articles for many top trade publications and has been quoted as a leading industry expert in Time, Business Week, MarketWatch, Annuity Market News, Investors News, Dow Jones Newswires and the personal finance column of many of the country’s largest newspapers.