Annuity Maximization

This Alert examines how a tax-deferred annuity may not be the best solution for senior clients. It demonstrates how a single premium immediate annuity, or “SPIA” may be a better alternative for clients, especially if the client is in a lower tax bracket than the children who will inherit it.

Often seniors invest in tax-deferred annuities as a safe, tax-deferred investment to pass on to their children. But many seniors are in relatively low income tax brackets. Often the annuity salesman does not consider that the children beneficiaries are in higher income tax brackets than the senior. In such a case it may be counter-productive for the senior to invest in a tax-deferred annuity.

If the senior has already purchased a tax-deferred annuity and is in relatively good health, a strategy to maximize the after-tax transfer of wealth to children might be to convert the tax-deferred annuity to a single premium immediate annuity (SPIA). The SPIA would pay a guaranteed income to the senior, either for a specified period of time or the lifetime of the senior. The guaranteed payment would be part interest income (current and deferred) and part return of the original investment in the annuity. The portion of the payment attributable to the interest income would be subject to income taxation. The portion of the payment attributable to the original investment (principal) is not subject to income taxation because it is a return of the investment itself, i.e., a return of “basis,” and not a return on investment. The longer the tax-deferred annuity has been owned by the senior, the greater the portion of the annuity that will be taxable. However, in all cases some portion of the annual annuity payment will be tax-free.

As an example, a SPIA for $100,000 might pay to the senior as much as $14,000 per year for ten years, with a fixed portion (such as sixty percent, or $7,400) of each payment being income tax-free as return of principal. The balance of the annual payment (in the above example, $6,600) would be taxable as interest income. Of course, if the deferred annuity had only been owned for a short period of time, the income tax-free percentage of the annual SPIA payment would be much higher. If the senior had owned the deferred annuity for many years, the taxable portion of the annual SPIA payment could be greater than the tax-free portion of the annual SPIA payment.

Assuming the senior is healthy, he or she can use the $14,000 annual payment (less an amount held for income taxes) to pay the annual premium on a life insurance policy. If the senior is not healthy, but has a spouse, sibling or friend who is healthy, the life insurance can be purchased on that individual. Upon the death of the insured person, the death benefit will pass to the children income tax-free.

If the senior has an estate large enough to be subject to estate tax (in excess of $5 million in 2011 and 2012; lowering to $1 million or more starting in 2013), the deferred annuity will be subject to both income tax and estate tax which could be as high as seventy-five percent or more of the value of the annuity. The tax bite significantly reduces the net amount received by the children as beneficiaries upon the death of the senior.

In this circumstance, an estate planning attorney should be engaged to create an irrevocable life insurance trust, or ILIT, for the senior. After the ILIT, the senior can gift or loan the net proceeds from the annual SPIA payments to the ILIT trustee, who can then use that amount to purchase the life insurance on the insured. By incorporating an ILIT into the planning strategy and properly administering the annual payments, the death benefit from the life insurance purchased on the insured will pass free of income tax and estate tax to the children, an increase of tens of thousands, if not hundreds of thousands of dollars to the beneficiaries.