Comparing Annuities to Life Insurance Life insurance is a product designed to leave money to persons the insured leaves behind when the insured dies. That money may be left for the direct benefit of the beneficiaries or it may be intended to pay taxes and other expenses of the decedent in order to preserve his accumulated assets or estate. If a life insurance contract has cash value, any growth or gains are tax deferred, and the owner of the policy has access to the cash value through policy loans (or withdrawals in some contracts) prior to the death of the insured. When the death benefit is paid, it is generally received by the beneficiary tax free. The value of the life insurance proceeds is includable in the owner’s estate for estate tax purposes. Annuities are products designed to benefit living annuitants by providing income throughout their lifetime. That income will be fully or partially taxable. An additional benefit, owing to its life insurance roots, is that the annuity value may be passed to a beneficiary if the owner dies before the contract is annuitized. However, unlike life insurance, that death benefit is not always tax free (in fact, it is rarely entirely tax free). Any amount the beneficiary receives in excess of the cost basis will be taxable to the beneficiary as ordinary income. Proceeds from a qualified annuity, because it has no cost basis, will be fully taxable to the beneficiary. Perhaps the best way to describe the difference between life insurance and annuities is to understand the difference in the owner’s objective; life insurance is designed to protect against the financial turmoil when a person dies too soon. Annuities are designed to protect against the financial turmoil of living too long. Together, they address two basic aspects of life—not living long enough to reach financial independence and living so long as to deplete all the money one has saved. Comparing Annuities to Retirement Plans (cont.) From a taxation perspective, annuities and most retirement plans share a number of common characteristics. Once money is contributed to the annuity, it grows income tax deferred, like a retirement plan. If it is a VA, whether qualified or nonqualified, transfers between subaccounts to maintain or change the portfolio’s asset allocation are not considered a sale and are not subject to capital gains tax. Distributions from both annuities and retirement plans are taxed as ordinary income. Once money has been paid into the annuity, there is virtually no way to access that money without an income tax liability. Like retirement plans, certain withdrawals prior to age 59½ are subject to a 10% penalty tax (the only escapes in annuities are the death or disability of the owner). All withdrawals must come from gains (earnings) first (LIFO), making those withdrawals taxable. Generally, the only way to obtain money from an annuity without an income tax liability is when a nonqualified VA has lost value and is now worth less than its cost basis. Withdrawals in that situation would not be taxable, and it would generally not create a deductible capital loss. And as has been said, the beneficiary of an annuity will incur a tax liability on any gains over the annuitant’s cost basis the beneficiary receives. Special distribution and tax rules apply when the beneficiary is the spouse of the decedent. If the annuity is qualified, the owner/annuitant will be subject to Required Minimum Distributions (RMDs). Beginning at age 70½ (technically, by April 1 of the year following the year one turns age 70½), the owner may need to withdraw funds from the annuity to satisfy his RMD amount for the year (the value of all qualified plans are aggregated to determine the RMD; however, withdrawals may come from any one or more of the plans). It does not matter whether a person needs the money or not; failure to take the RMD in whole or in part results in a 50% penalty tax on the undistributed amount. However, when a qualified annuity has been annuitized, the RMD rules do not apply because the payments represent a series of substantially equal amounts based on the annuitant’s life expectancy and the IRS distribution tables, and they are already generating income tax liabilities. The singular exception to all of this is an annuity that holds Roth retirement account assets (Roth 401(k), Roth 403(b), or Roth IRA). Because Roth accounts are not subject to the age 70½ rule, distributions are not required, and the annuity is never required to be annuitized. When the owner/annuitant dies, a beneficiary will receive the annuity tax free, along with the ability to withdraw the proceeds both penalty and income tax free, regardless of the annuitant’s age. As the beneficiary, a spouse may continue the Roth IRA as his or her own and may contribute earned income every year with no requirement to ever take any distributions. If the beneficiary is not the spouse, then certain minimum withdrawals will be required based on life expectancy, but this favors younger beneficiaries, and the account may continue to grow in value. Without ever annuitizing, it may be passed on repeatedly to other beneficiaries in future generations until the account is depleted, providing tax-free income for multiple lives. Many life insurance producers are unaware of this, and it is a seldom exploited, yet perfectly lawful, use of qualified annuities.
Posted on: Fri, 27 Sep 2013 02:45:53 +0000
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