Many people struggle to understand annuities and wonder if they really need one or not. To help shed light on this situation, let’s look at one example.
“Tom,” a 60-year-old widower, purchased an annuity 20 years ago. Should he repurpose or replace the annuity with a more tax-efficient asset such as life insurance?
Most individuals who purchase a deferred annuity find that, at retirement, they no longer need it for income purposes. In many cases, the intent is to pass the funds to their beneficiaries. While a deferred annuity can be a great way to accumulate funds for retirement, it generally is not an efficient vehicle for wealth transfer because it has the potential to be taxed twice at death.
DEFERRED ANNUITIES AND POTENTIAL DOUBLE TAXATION
Depending on the ownership structure, a deferred annuity may be subject to both ordinary income and estate taxes at death because the gain on an annuity is subject to ordinary income tax and the annuity itself is part of a client’s taxable estate. This double taxation can significantly reduce the value of the death benefit, so that heirs receive only a fraction of the intended amount.
To solve this problem, the policy owner can reposition the deferred annuity.
Annuity maximization is simply an asset repositioning strategy in which the annuity is exchanged for or transferred to a Single Premium Immediate Annuity. A SPIA provides an income stream for a chosen number of years based on a single premium payment made at purchase. This method can provide a consistent, predictable stream of income to fund a life insurance policy.
When Tom purchased a deferred fixed annuity in an IRA 20 years ago, his intent was to use the funds as a Social Security income supplement during retirement to ensure that he and his wife, Sally, would be able to live comfortably. Now, five years from retirement, Tom finds that he has sufficient assets in his 401(k) and investment accounts that he does not anticipate the need to utilize the annuity, now valued at $100,000, for income purposes.
After Sally passed away three years ago, Tom’s primary concern now is leaving his son and daughter an inheritance. The funds are to be split equally between them after Tom’s death. The money each child receives would be taxed as ordinary income, leaving each beneficiary with less than Tom would like to provide.
Tom is rather healthy, so his agent recommends that he consider executing a qualified transfer of his IRA annuity to an SPIA, then using the income generated from the SPIA to fund a life insurance policy. His good health will ensure low insurance rates, meaning Tom’s money will go much further in establishing an inheritance for his children.
HERE’S HOW THE PROCESS WOULD WORK:
- Tom transfers the $100,000 from his IRA annuity to a 10-year period certain SPIA, meaning that either he or his beneficiaries would receive an annual income of $11,026 for 10 years.
- Assuming a 24% tax bracket, Tom would have an after-tax amount of $8,379 each year of his life to be used as a life insurance premium.
- Tom uses the SPIA proceeds to purchase a 10-pay whole life insurance policy.
- Assuming a Preferred rate class, Tom would be able to leave a tax-free guaranteed death benefit of $167,281 to be split between his son and daughter.
In choosing to reposition his deferred annuity, Tom can maximize the amount passed on to his heirs. Not only does his life insurance policy yield a higher death benefit, the life insurance proceeds may be tax-free.
The case study is intended to provide an illustrative example only; each individual’s situation is unique and should be evaluated separately. All applications will require evidence of insurability and underwriting; the rate classes and individual offerings may differ from this example. There is no guarantee of eligibility or of a specific tax consequence. Neither The Cincinnati Life Insurance Company nor its affiliates or representatives offer tax or legal advice. Consult with your tax adviser or attorney about your specific situation.