There is a plan that might boost your current after-tax investment income and increase the estate left to your heirs. Especially if you own bonds to generate income, including tax-free bonds, consider this strategy as part of both your investment planning and estate planning.
A problem with bonds, even tax-free bonds, is that estate taxes can take a chunk of the bonds before they get to your heirs. If your estate is large, as much as 55% of the bonds will be siphoned for estate taxes. Even “tax-free” bonds are subject to estate taxes. They avoid only income taxes on their interest payments.
Suppose you have $1.5 million in bonds that are generating about $80,000 in annual income. On your death, if you are in the 50% estate tax bracket and don’t have insurance to pay the taxes, your heirs will get only $750,000 of bonds. That will generate less than $40,000 of interest income for the heirs.
There’s a way you might be able to change these results without shortchanging your current income.
First, sell the bonds. There might be capital gains, depending on when you bought them. Use the sale proceeds to buy an immediate annuity. (See last month’s quarterly report for details about annuities.) To maximize lifetime income payments, you can buy an annuity that makes payments only for your life.
The annual payments from the annuity will greatly exceed the bond income in many cases, partly because some of each payment will be a return of your principal, and partly because there will be nothing from the annuity for your heirs. The portion of the payments that are a return of your principal are tax free. That will further boost your after-tax income.
Part of the additional income can be used to purchase a life insurance policy payable to your heirs. Either your heirs or an irrevocable trust should own the policy to avoid estate taxes. The insurance benefit should equal the original $1.5 million value of the bonds.
The result under this plan often is that your annual income is increased, even after subtracting the insurance premiums. In addition, the heirs get to inherit the full $1.5 million tax free. The disadvantages are that you do not have control over $1.5 million in assets any more. You get a higher annual income but cannot tap the principal, except under limited circumstances that depend on the annuity.
The older you are, the greater the annual payments from the annuity will be. Also, the older you are the greater the portion of each payment that is a tax-free return of your principal, further boosting the after-tax benefit to you.
The life insurance policy is an important part of the strategy. Don’t sell any bonds until you have had a physical exam and qualify for an insurance policy.
The strategy will work with any type of asset. You don’t need a portfolio that is heavy in bonds. But be sure to know the capital gains liability from selling the asset. You’ll be able to buy an annuity with only the after-tax sale proceeds.
Under this strategy, the amount your heirs will inherit is fixed by the insurance policy. If you own assets that are likely to appreciate and sell them to execute this strategy, your heirs will lose any after-tax growth from the assets. You have to estimate what that growth would be after estate taxes to decide the better strategy. But you might get the best of both options by purchasing a variable life policy directing the investments to growth assets.
Be sure to shop around for an annuity. Payments from even major, safe insurers differ by as much as 20%. Don’t leave that much cash on the table by not shopping around.
You don’t need to be in the highest estate tax bracket to use this strategy, because purchasing the annuity can boost your annual income even after paying for insurance. That means your heirs would be no worse off under this strategy, and your standard of living could be increased by higher annuity payments.
Examine the numbers carefully and work with a financial advisor. Determine if you and your heirs can benefit from converting your bonds or other assets into annuities.