Own annuities?

You are in an expensive tax trap...but you can escape

If you own annuities, this article is must reading. If you intend to buy annuities, read this article before you buy.

It should be noted that most insurance companies have many annuity products, each a bit different. There are literally thousands of possibilities. Despite that, the type of annuity most often sold is a "deferred annuity," the subject of this article.

Why do so many people buy deferred annuities?... Because they are charmed by the annuity salesman's standard industry sales pitch. Remember, almost all American taxpayers hate paying taxes. Knowing this, the insurance industry teaches its sales people to highlight that earnings (on the amount invested in the annuity) are tax deferred. This means that when the value of your annuity account goes up (really profits), no tax is due on those profits until you actually take the funds.

Sounds great. But unfortunately two sad facts haunt every deferred annuity:

  • You bought a lousy insurance policy
  • You created a tax trap.

Here's what Ken Fisher, author of the Portfolio Strategy for 30 years in Forbes; says: "The vast majority of annuities are really complicated insurance policies that make it very difficult to fully understand the implications and unintended consequences. And once you buy into an annuity, it can be a very difficult and potentially, very costly investment decision to reverse."

Let's explore the two sad facts, one at a time, using Joe as an example.

The lousy insurance policy

Joe (a healthy 60-year-old) buys a $500,000 deferred annuity. When Joe goes to heaven, the annuity is worth $960,000 (includes a $460,000 profit). The beneficiary is his son Sam. Yes, Sam gets the full $960,000. But wait, if Joe had purchased a life insurance policy with that $500,000 as a single premium, the death benefit—free from income tax and estate tax—would be in the $2-million range.

Worse yet, the entire $960,000 is subject to estate tax in Joe's estate... also the $460,000 profit is taxable income in the year Joe dies. Double-taxed. Ouch!

A FACT: Studies every year show that over 90% of all deferred annuities are held (never annuitized) until the owner's death, like Joe above.

A real-life example

Scott (a real-client) is 75 years old and in good health. Scott owns an annuity that cost him $734,916 and has a current value of $2,015,749 (so has a deferred profit of $1,280,833). Suppose Scott gets hit by the proverbial bus... He's in heaven. Because of the crazy new income tax rates under Obamacare, income from annuities are subject to a top "unearned income tax rate" of 39.6% and an additional "surcharge" of 3.8%. That's a total tax rate of 43.4% on the $1,280,833 deferred profit. So, what's the income tax burden?... $555,882.


Wait, there's more to this tax horror story: The value of the annuity (less the income tax burden) is subject to a 40% estate tax. The tax liabilities—income and estate—will only get worse as time goes by as the value of the annuity continues to grow. Simply put, the double tax liability ($1,139,829) will never go away... only increase. You are in a tax trap.

How to escape the double tax... while creating additional (tax-free) wealth

We have used the following strategy many times to escape the tragic deferred annuity tax consequences. It is a simple two-step process:

  • Step #1 — Annuitize the annuity value ($2,015,749)... The insurance company agreed to pay Scott $170,968 (annual annuity) every year, for as long as he lives.
  • Step #2 — By law a portion of Scott's annual annuity is subject to income tax. We used the after-tax annuity amount ($123,461) to pay the annual premium on a life insurance policy on Scott for $2,681,166. All tax-free: no income tax according to the Internal Revenue Code... no estate tax because the policy is owned by an irrevocable life insurance trust. What's cool about this strategy is that as long as Scott lives, he is guaranteed to collect the annuity and will always have funds to pay his premium.

A few important things you should know:

  • Scott's tax-free insurance proceeds $2,681,166
    • After-tax value of deferred annuity 875,920
    • Increase in after-tax amount (Wow!) $1,805,246
  • In a 43.4% income tax bracket and 40% estate tax bracket you must earn $2,944,641 to leave your family $1,000,000. So, you can see the above increase of $1,805,246 gives about the same after-tax results as earning about $5.4 million. Lesson learned: stay out of double-tax situations, like deferred annuities.

The above strategy works for one life (you are single or, if a couple, only one spouse is insurable) or two lives (second-to-die insurance for husband and wife).

Twisted my insurance guru's arm.. so he agreed to review the possibilities for readers of this column who own annuities. Just two rules:

  • You should own $500,000 or more in annuities (current value) that have not been annuitized
  • If single you are insurable or if married, at least one spouse (or both) is insurable.

Interested? Gather the following info: full name and birthday for those to be insured; your address and all phone numbers (business, cell, home) where you can be reached; a list of your annuities (only those not annuitized... just name of insurance company, original cost and current value). Send it to Irv Blackman, Annuity Strategies, 4545 W. Touhy Ave., #602, Lincolnwood, IL 60712. 

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