Financial Advice for Retirement, Social Security, IRAs and Estate Planning

Profiting From “Excess” Annuities & Insurance


Many of you own annuities or cash value life insurance that no longer fit your needs. They were good ideas when you bought them. But times have changed, and so have your needs. Fortunately, there are strategies you can use to enhance the value of these policies to you. Let’s look at a creative strategy that will greatly increase the after-tax value of these excess assets.

Suppose you have an annuity that you bought years ago. You don’t need the annuity to generate income for retirement. It is basically a tax-advantaged savings account that you plan to pass on to your children. But look at the results. As I’ve pointed out before, the annuity will be included in your estate. That means taxes up to a 55% rate. After that, your children pay income taxes on the appreciation in the annuity just as you would if you made withdrawals. If you paid $50,000 for an annuity that now is worth $100,000, your children will owe income taxes on the $50,000 appreciation. This applies whether it is a variable or fixed annuity.

In most cases, heirs end up with 40% to 60% of the annuity after all taxes.

Here’s an option. Cash in that annuity yourself and pay the taxes. If you are in the 40% tax bracket, you’ll pay $20,000 in taxes and have $80,000 left. You can take that $80,000 and use it to buy a life insurance policy payable to your children. Put the policy in a trust or give it outright to your children to avoid estate taxes on the benefits.

An $80,000 premium is going to buy a life insurance benefit greatly exceeding $80,000. The exact benefit depends on your age and the policy you buy. The payoff ratio is bigger for younger individuals. Your heirs won’t owe any income taxes on the benefits. So you turn the $80,000 into a far larger inheritance than you could have generated with the annuity, and your children won’t owe income taxes on the benefits. You can avoid the estate taxes by transferring the life policy to your children.

The results can be even better over time if you purchase a variable life policy. As I described in the January issue, you can invest the cash value account of a variable life policy in mutual funds. Your cash value and policy benefit will change with the performance of your investments. That gives you an advantage over traditional cash value life insurance.

Suppose you like the idea of converting the annuity to life insurance, but you want to keep the ability to tap the account for cash during your retirement in case of emergencies. You still can do that with life insurance, but you won’t be able to give the policy to your children and get it out of your estate. You can take withdrawals or loans from the policy cash value.

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Loans don’t have to be paid back. They are subtracted from the eventual policy benefit. Interest rates on the loan generally net out to 2% or less.

The tax treatment of loans and withdrawals depends on how you paid the premiums. If you paid the premiums over time, withdrawals are treated on a “first in, first out” basis. That means the premiums paid are considered withdrawn first until you have withdrawn an amount equal to your total premiums. Premium withdrawals are tax free. Withdrawals above that amount would be taxable as ordinary income. Loans also are tax free.

To get this favorable treatment you have to meet what is called the “seven-pay test.” That generally means you have to make premium payments in equal installments over at least seven years. Your insurer determines the exact schedule and whether or not you meet the seven-pay test.

If you buy the policy with a lump sum premium or otherwise don’t meet the seven-pay test, then you get the opposite treatment. Loans are treated as taxable distributions. And withdrawals come first from accumulated appreciation, which is taxable. Only withdrawals that exceed appreciation are nontaxable withdrawals of premiums.

That means to convert an annuity and to a variable life insurance policy and get the most favorable tax treatment, simply convert the annuity in stages. Every year for seven years, take a distribution from the annuity, pay the taxes, and use the after-tax amount to pay a life insurance premium. In the worst case you die before the process is done and have managed to convert only part of the annuity. Your heirs still would be better off than if you did nothing and let them inherit the annuity.

Determine the taxable amount in your annuity, and compute the after-tax liquidation value of the annuity. Finally, shop around and determine how much life insurance you would get for that after-tax amount. Don’t forget to check the policy offered to Retirement Watch subscribers described in the insert with this issue.



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