CASE STUDY: Annuity Maximization

Current Situation:
Unlike an IRA, rules requiring minimum distributions to begin at age 70 1/2 do not apply to fixed or variable annuities. Annuity holders who do not need the income it can provide during retirement, may hold onto the asset until death to maximize income tax deferral, intending to pass the annuity to their heirs.

However, an annuity is subject to both income and estate taxes at death, which may significantly erode the majority of the annuity balance before it can be passed to heirs.

Possible Solution:
Instead of holding the asset until death, individuals can gift the stream of income from the annuity to an insurance policy owned either by children or an insurance trust. This strategy turns a taxable asset into an income-generating vehicle for heirs – while initiating a sound tax planning strategy.

How it Works:

1. Convert the annuity to a single premium immediate annuity (SPIA), which provides a steady stream of income; or take a withdrawal from the deferred annuity.
2. Fund life insurance within a trust, or owned by the children. Gift the annuity income to an irrevocable life insurance trust or directly to the children. That trust then purchases an insurance policy on the life of the annuity holder, or on the lives of the annuitant and his/her spouse.

Benefits

• An annuity holder who does not require the income during his or her lifetime can convert an asset that is double-taxed at death into one that provides tax deferral during life and pays a benefit to heirs at death that can be free from income tax and, if structured properly, estate taxes as well.
• The taxable portion of income generated by the SPIA is limited to the exclusion ratio only.
• If the annuity holder is insurable, the life insurance benefit provides maximum leverage and favorable tax advantages to the participant.
• If both the annuitant and spouse buy a Second to Die policy, the death benefit leverage is even greater.

Risks/Considerations:

• Results are subject to changes in current tax laws.
• If the annuitant lives beyond life expectancy, the taxable portion of income generated by SPIA can be higher than the exclusion ratio percentage.
• The feasibility of strategy depends on the insurability of the participants.

CASE STUDY EXAMPLE—BOB AND JENNY JONES
Annuity owners:	Bob Jones, age 70, good to average health for his age Jenny Jones, age 68, good to average health for her age
Deferred Fixed Annuity Amount:	$1,000,000
Current situation:	Have sufficient income from other sources Estate valued at $7,000,000 Have not used $1.5M unified credits Currently making $5,000/year gifts to each of three chilldren
Objectives:	Tax deferral Minimize taxes Pass on annuity to heirs
Possible Solutions/Outcomes:	1. Convert the $1,000,000 deferred annuity to a single premium immediate annuity. Assumptions: Joint and survivor 100% annuity payout. Income continues to be paid to Jenny at Bob's death. 34.6% is subject to income tax with each payment based on exclusion ratio. Projected income stream per year: $71,170 2. a) Purchase a Second to Die policy, using the income stream to pay premiums over the life of the policy. b) Set up an insurance trust to own the policy or kids can own c) Use the annuity payout stream as follows: Annual Premium/Gift to the Trust: $71,170/ yr Life Insurance Owned by the Trust: $4,651,547
Life Insurance Internal Rate of Return on Death Benefit:	Year 1 Year 10 Year 20	6,435.84% 32.89% 10.30%
Death benefit guaranteed to Jenny's age of 100 regardless of market performance.

 

The material is for informational purposes only. Although this strategy may involve tax, legal, and accounting information, we are not offering such advice and suggest you consult your tax professional and advisors. Trusts are drafted by attorneys. Transition costs of converting deferred annuities to SPIA's or taking withdrawals may occur, so this should be examined carefully. The SPIA has been illustrated with First Colony as of 1/05. Rates change on a monthly basis. The life insurance policy assumes Standard NS risk class for both individuals. The carrier illustrated is Pacific Life. This is not a contract or policy, and the carrier's illustration should be attached showing all legal disclaimers. Insurance services provided by Mesirow Insurance Services.