May 2001
Transferring Annuity Accumulations
By Michael A. Kirsh, CFP, Kirsh Financial Services, Inc., New York City
Many individuals have invested significant amounts of their retirement savings in tax-deferred annuities. Through tax-deferred growth, these investments have provided greater wealth accumulation than available alternatives. Owners that do not need to use the entire accumulated value during their lifetimes may desire to pass some, or all, of it to their heirs.
Yet while annuities may be effective in accumulating wealth, they are not effective in transferring it. Like an IRA, the gain in an annuity becomes income with respect to a decedent (IRD) upon the death of the owner. Annuities are subject to both income and estate taxes, so heirs could receive less than 30 cents on the dollar.
Example
Consider the case of a female, age 75, with an estate that includes an annuity worth $500,000 with a $50,000 cost basis. If her daughter were to inherit such an estate immediately, the marginal taxation of the annuity, assuming an estate in which the annuity would be taxed at the 50% rate, would consume all but $170,000, or 34%, of the value of the annuity (see row 1 of the Exhibit).
Over time, the percentage of the annuity that will pass to the daughter after taxes will decrease further. If the annuity grows at an average rate of 6% and the mother lives to 100, the annuity will grow to $2,145,935, but the daughter will receive only $663,781.
Annuities have other limitations. Unlike an IRA, an annuity cannot be continued by the daughter; within 60 days of the owner’s death, the daughter would have to elect either a life annuity or distribution of the entire contract within five years. In addition, under IRC section 1035, annuities can only be exchanged for other annuities.
Strategies
The first step is for the inheritor to annuitize the contract. In the preceding example, she would give up the $500,000 and receive a guaranteed lifetime income of $54,409 per year, less income taxes of $20,164. This would leave $34,245 in annual income that could be used to purchase a $900,000 life insurance policy (assuming she satisfies the underwriting risk). This premium would fully guarantee the death benefit until age 100 (note that, beginning in year 12.5, the full annuity payment would be taxable). Newer products have been developed that allow individuals to annuitize without giving up their right to the principal.
The $900,000 death benefit will always be greater than the net after-tax annuity proceeds—even 25 years later, when the sample recipient would be 100. At age 75, the death benefit is $731,000 more than the annuity proceeds and at age 100, the benefit would be $246,219 more—both substantial amounts.
This solution also applies to individuals with smaller estates. If the annuity is an individual’s safety net, the earnings could be used to purchase life insurance and maintain the principal as a safeguard against future contingencies.
Editors:
Milton Miller, CPA
Consultant
William Bregman, CFR, CPA/PFS
Contributing
Editors:
Theodore J. Sarenski, CPA
Dermody Burke & Brown P.C.
David
R. Marcus, JD, CPA
Marks, Paneth & Shron LLP
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