Less Annuity Tax and More Benefits for Heirs

Owners of annuities often hear a "good reports, bad news" saga from their economic and tax advisors. The good news may be their investment has gone up in price; the bad news is that whenever they die, their beneficiaries will need to pay income tax at ordinary income rates upon that growth. There is, nevertheless, a way to eliminate the "bad news" part of this story and pass more dollars through wise payment of annuity tax.

Let's take the situation of Sally, age 70, a widow with one daughter. Right after her husband died, a decade ago, Sally sold her property and invested part of the money in a variable annuity. In spite of the recent downturn in the market, Sally's variable annuity nearly doubled in worth over the time she has held it. But she has also been reminded that her child, who is in the 35% tax bracket, might eventually have to pay income tax on these gains as Sally has no plans to use the annuity herself.

Since sally does not need income from her variable annuity at this time, one method would be to have her daughter buy a life insurance policy on Sally's life. It's better that the daughter get proceeds form a life policy, which are completely tax free, than from an annuity, with completely taxable gains.

To pay for the policy, Sally could annuitize the variable annuity. She'll receive a lifetime income and manage to give her daughter enough money to pay the life insurance premium payments. Any of the variable annuity withdrawals that Sally does not spend, may be invested in any way Sally desires.

What makes this even better is the annuity tax exclusion ratio (as soon as Sally annuitizes her variable annuity contract, the exclusion ratio applies to a portion of each and every payment to determine the percentage that is taxable).

This process of substituting a life insurance policy death benefit for that death benefit of an annuity provides 2 kinds of positive annuity tax arbitrage:

1) Sally pays the standard income tax but she has a lower tax rate than her beneficiary

2) Life insurance tax benefits are tax free to the particular beneficiary

There are very few instances where we have not seen this "trading" of an annuity for a life policy to benefit all parties involved when the annuity owner had no intention to use the annuity. Even though the owner must pay annuity tax to do this, there is no out-of-pocket costs as the payments from the annuity are used for annuity tax payments.