What Annuity Problem?
Let’s use an example to explain. Clara and Thomas have conservatively purchased a fixed annuity with a flat rate of return. Over the years, they have watched their initial investment of $2 million grow to a sizable $5 million. A fixed annuity is tax-deferred, and the principal and interest are guaranteed. Sounds pretty good until their favorite uncle shows up (Uncle Sam, that is). When they want to access the funds, they have to pay income taxes on the growth. Most concerning, however, is if they don’t need the cash, and the annuity becomes part of their estate. Then their children, Jack and Anna, will likely only receive half the money, in this case $2.5 million. After decades of investing in what seemed like a low-risk solution, the final value is not much more than the amount invested.
Where Did the Money Go?
Upon their death, estate taxes became payable in addition to income taxes (which were deferred until then). In some cases, the IRS may recognize that income taxes and estate taxes will be owed on the same assets, and so the estate taxes may be deducted from the decedent’s income. As a result, we assume that the estate only owed 10% in income taxes on their fixed annuity, in addition to the 40% standard estate tax. In sum, a fixed annuity in a large estate owes at least 50% in taxes, and quite possibly more, depending on the circumstances.
What about Indexed Annuities?
In case you were wondering, let’s take a minute to address the difference between an indexed annuity and the fixed annuity mentioned above. In both cases, the principal is guaranteed and the growth is tax-deferred. However the indexed annuity has a rate of return that is pinned to an index, such as the S&P 500. In that case, there could be a lot more upside potential, but no downside potential. While taxes will become due upon withdrawal, and estate taxes may become payable as well, the growth is likely to more than compensate for the loss in taxes. Thus, the annuity problem we are discussing is most likely only a fixed annuity problem.
Do We Take the Money and Run?
It may seem like drawing down on a fixed annuity would make more sense than leaving it to be mercilessly cut in half after you pass on. However, there are a few important issues to consider:
- If you are younger than 59.5 years old, you will be charged a penalty for early withdrawal on the fixed annuity.
- To liquidate the annuity, you may choose to receive a lump sum. However, in this case the deferred taxes are owed all at once.
- You can begin to draw down a specific amount every month for the rest of your life (and if you are smart, you may also add your spouse, so the payments continue until the 2nd spouse has passed away). Unfortunately, this plan leaves no estate, and runs the risk of the insurance company keeping most of your money. For example, let’s say you have a $2.5 million annuity, and agree to receive $100,000 per year for the rest of your life. If you (and your spouse) pass away in the first year, you will have only received $100,000, and the insurance company will be released of any and all obligations, happily pocketing the remaining $2.4 million you painstakingly saved.
There seems to be no good way out of a fixed annuity, and holding onto it is even worse.
So How Do We Solve the Problem?
We have a solution that would save the investment from a hapless ending. Here is your ticket to freedom:
- You can exchange your fixed annuity for an immediate annuity using a 1035 Exchange. This part of the tax code states that any annuity may be exchanged for another annuity without being subject to withdrawal penalties or triggering income taxes.
- You can choose an immediate annuity that pays a fixed amount for the rest of your life, and your spouse’s life (if applicable). The income you receive will be part taxable (the interest portion) and part tax free (the principal portion).
- You create an irrevocable trust, which takes out a life insurance policy on your life. The funds from your immediate annuity will be used to pay the premiums on the insurance policy.
- Rest assured knowing that the full death benefit will be paid out to your beneficiaries; no estate tax or income tax will be owed. The annuity will ensure that as long as you live, you can pay the life insurance premiums. And even if you die prematurely, the life insurance policy will pay out the full death benefit to your beneficiaries.
Did You Know There Is the Potential for a 4:1 Return?
We discussed how you can eliminate risks, but you can also leave a much larger legacy than originally planned. Let’s take the example of Clara and Thomas, and their $5 million fixed annuity. They follow the plan above, and immediately begin to receive $120,000 in an annual payout from the annuity, which gives them enough money to fund a $10 million life insurance policy (in a trust). Now, instead of passing on $2.5 million to their children, their children will receive a whopping 4 times the amount! Case closed.
If you or your clients have a fixed annuity, and would like Axia Global to help determine if this solution will work for you, please give us a call. It is our goal to make a measurable difference in your financial life.
Note: the statements above should not be considered financial, legal or tax advice, but ideas for careful consideration with your trusted financial advisors and lawyers. For current tax or legal advice, please consult with an accountant or an attorney.