Income Shielded by Annuity use for Life Insurance Payments

The transfer of wealth may require a more sophisticated strategy than an annuity by itself. Large deferred annuity contracts will not, by themselves, transfer to your beneficiaries automatically without tax consequences. The following example demonstrates how a deferred annuity, our greatest wealth accumulation vehicle, can be used in conjunction with other strategies to minimize estate tax burdens.

Imagine you are 70 years old and you invested $100,000 in an annuity contract 20 years ago. If you earned 10 percent a year over this 20 year period, your contract is worth $750,000. You have an estate (excluding the annuity) in excess of $600,000 and you are in the 37 percent marginal estate tax bracket. You also name your son as the annuity beneficiary and he is in a 35 percent income tax bracket. What would happen to the contract's account value if you die today and the annuity value was transferred to your son (see example on this page)?

Your son would receive just over one-third of the contract's value. The rest would be lost to estate and income taxes. Since you owned the contract at your death, its value is included in your taxable estate. The gains in the contract's value are also completely income-taxable to your son, since there is no step-up in cost basis at the death of an annuity owner.

So to avoid estate taxes on the annuity value, you suggest transferring the contract to your son as a gift. You don't think you will need any income from the contract. Unfortunately, if an annuity contract is given to an individual to whom the owner is not married, not only may there be a gift-tax consequence, but the contract owner will recognize all of the interest and gain earned inside the contract over the years as taxable income in the year of the transfer. This applies to annuity contracts issued after April 22, 1987. Contracts issued before April 23, 1987 are treated differently, with the interest and gain recognized by the donor if and when the donee surrenders the annuity contract. Only married individuals can transfer annuity contracts to each other without triggering any of this income recognition.

Instead of giving away the annuity contract, a possible solution is available by using the contract itself. The purpose behind an annuity contract is to provide a guaranteed income stream for either a number of years or over the annuitant's lifetime. By selecting an immediate income option, either from the original contract of through a tax-free exchange to a more competitive immediate annuity, you can increase your current income and spread the taxable gain in the deferred annuity contract over the years you receive the payments.

If you are under age 59½ there could be a 10 percent premature distribution tax. If you select a life only annuity, annuity payments stop at the annuitant's death and there is no contract value included in your estate.

What about a benefit for your son? In our scenario, you may think you don't need the annuity income to pay living expenses. You could convert the contract value into an income stream to fund a life insurance policy owned by an irrevocable trust for your son. Unlike the annuity contract, the proceeds from a life insurance policy are generally income-tax free. In addition, if the life insurance policy is owned by a third party from the start, e.g. a trust, you should be able to keep the proceeds out of your taxable estate.

The immediate annuity income you receive will be partially income taxable, as the gain from the deferred annuity contract is spread over the years of payment. You might keep part of the income to pay the related taxes; then you could give some or all of the remainder to an irrevocable trust or to your son with which he can pay the life insurance premiums. A number of strategies could be employed with such transfers to minimize gift tax consequences, too.

Perhaps you own a tax-deferred annuity contract but do not have a sizable estate. Is there any reason to select an immediate annuity and fund a permanent life insurance policy? The answer is yes, if you do not need current or future income from the annuity contract and the idea of maximizing wealth for transfer to heirs is appealing.

In this situation, you could own the life insurance policy and have access to the cash value should the need arise. However, at death, unlike the annuity contract proceeds, the life insurance death benefit would generally pass to the named beneficiary income-tax free.

In addition, the leveraging associated with a life insurance policy's death benefit might help you leave your son a lot more cash than could have been achieved with other assets. Of course, the policy proceeds would be included in your taxable estate if you owned the policy at death.

What about a married couple? Between spouses, not only can an annuity contract be transferred during their lifetimes without any income recognition, but a tax-deferred annuity can usually be transferred at the death of the owner to his or her spouse on a tax-deferred basis.

Each contract must be reviewed carefully to make sure this can be achieved at the death of the primary annuitant and/or owner. With the availability of the unlimited marital deduction for estate taxes, neither income nor estate taxes would occur at the first spouse's death, but at the second spouse's death, non-spousal beneficiaries must deal with possible income and estate taxes.

The planning process for a married couple is often similar to that of a single individual. However, the immediate annuity option chosen might be a joint-and-survivor one and the life insurance policy used might be a second-to-die contract. Depending upon the couple's financial and estate-planning situation, using a joint-and-survivor immediate annuity and a second-to-die life insurance policy would allow them to accomplish the same transfer objective as a single person.

Adapted from an article by John Oliver, Director of Advanced Marketing, Transamerica Occidental Life Ins. Co.