ANNUITIES VERSUS LIFE INSURANCE
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There are a lot of people that go to advisers that want
to buy an annuity for their beneficiaries. Nice thought but almost universally
wrong.
Here is a real life example. A 70 year old man went into a bank and told
the representative that he wanted to put away $35,000 for his two grandchildren.
On its face, it seems like a generous thought. But the sale by the rep would
have actually been unethical- and financially stupid- save for the fact that
the agent got a commission.
Let's first see what would have been accomplished by the annuity. Assume
the$35,000 would have been invested at 6%. At the end of the first year,
the annuity would have been worth just $37,100. After five years, it would
equal $46,837. Assume the man then dies. The grandchildren do get access
to the money, but at one year, the account would have grown just $2,100 and
would be FULLY TAXABLE AS ORDINARY INCOME. At the end of five years, they
have $11,837 ($46,837 - $35,000), but it is also taxed as ordinary income.
BAD. Why? NO STEP UP IN BASIS. (See section on basis in
TAX.)So, what's my point?
Let's take the issue one step further by stating that the 70 year old man
was healthy. Literally any healthy individual can get life insurance. (Actually
you can get life insurance even if you are almost dead, but that is an item
discussed elsewhere.) And one further item is this. A lot of insurance is
sold- regular whole, universal and variable- to use the "benefit" of taking
out tax free loans. But remember that our individual is simply looking to
put money away that is not needed. He will not take out loans. Therefore
he should at least consider a MEC or Modified Endowment Contract. Under this
type of contract, he puts away the $35,000 now in an attempt to get as much
insurance coverage with just one payment. The issue is that if you put too
much money in during the first year (just what you want with an MEC), the
owner will NOT be able to pull out tax free loans- the loan is taxable. But
since the loan is irrelevant, it's exactly what he should look at. He tries
to get the maximum face value which I will estimate at $100,000 with a $35,000
single premium payment. Now he dies after one year. His grandchildren get
$100,000 TAX FREE. If he dies after five years (and I'll even state that
he gets no return on the investment in the policy) the beneficiary get $100,000
TAX FREE. LIFE INSURANCE RECEIVED BY BENEFICIARIES IS NON INCOME TAXABLE
AT THE FEDERAL LEVEL.
So at five years and a 20% federal and state) tax bracket (I'm taking some
liberty to say the assets are removed from the annuity), the kids got $44,469
($11,837- 20% tax plus the original $35,000) with the annuity versus $100,000
with the life insurance. Even if the policy was for $75,000, is it not still
better????
Tell me, which is better? In fact, using a 20% taxation, the man would have
to live another 21 years just to get the same amount that the insurance would
pay with NO cash value buildup. That would be about 11 years past the current
actuarial lifetime. Illogical.
Here is one last element that needs to be discussed as well. Assuming the
man bought either of these investments, once he died, the assets would be
included in his estate for estate tax purposes. If the total amount of
everything, including the annuity or life insurance) was under $675,000,
no estate taxes would be due. Under such a condition, he could have retained
ownership of the policies and the right to change beneficiaries. If, however,
his total estate was OVER $675,000, then estate taxes would be due starting
at 37%. If we assume the annuity was worth $45,000 when he died, the
beneficiaries effectively would lose 37% of that amount to taxes. If he had
life insurance instead, the beneficiaries would effectively lose 37% of the
$100,000- a much larger amount. However since the life insurance cost him
no more initially when purchased, the life insurance was still the best way
to go.
Is there a way to have avoided the estate tax- particularly where it involved
the life insurance. Yes, through the $10,000 gift available each year to
anyone. Assuming he had two grandchildren and $35,000, I might have looked
at what month he came to the office. Say it was August. In this case, he
could apply for an MEC policy with a lump sum of $20,000- the amount of a
gift for two people that year by giving that money to his children so they
would buy the policy for the benefit of the grandhildren. The policy would
be underwritten and paid for late in the year- say November or December.
And somewhere around October, he would have applied for ANOTHER policy of
$15,000 that would be underwritten (probably under the same APS) for payment
in January. That $15,000 is within the gift limitations for the following
year. The policyowners of the policy would be his children and the beneficiaries
would be his two grandchildren (different ways you could arrange this under
a UTMA) and the policy payments
upon death would NOT BE INCLUDED IN HIS ESTATE. Admittedly, he would have
lost the right to change beneficiaries, but maybe that was acceptable.
The point being with this discussion is that there were many various strategies
available that would have provided far more money to the beneficiaries and
even avoid the estate taxation issues. Unfortunately, agents tend to do what
people ask cause they can get a commission faster. But the above annuity
sale would have been wrong for all parties- particulary the beneficiaries-
if the man died during his normal actuarial lifetime. Even the sale of
traditional life insurance would have been wrong since it almost undoubtedly
would not have maxed the insurance amount as an MEC could have.
Lastly, regarding the use of variable annuities versus variable life insurance.
The life insurance will be more costly than the variable annuity, but the
distributions through a loan are tax free versus ordinary income for the
annuity. And if the owner dies prematurely, the beneficiaries are almost
undoubtedly presented with far more money with the insurance program. Outside
of doing the numbers to determine how much of a difference the accumulation
would be between the two different investment types after "x" years, there
seems to be little reason to buy variable annuities. You would get less as
an accumulation value with the insurance, but probably more on a before tax
basis with the tax free loans. And certainly the life insurance element is
a plus. The caveat is that you must keep the policy for life since, if you
terminate it, the proceeds above basis become taxable as ordinary income.
I would however indicate that a regular fixed annuity is fine for totally
risk adverse investors and the costs far less than a variable life insurance
policy. The use of a variable life policy is debatable for the risk adverse
consumer due to the lack of guarantees for the insurance and the amount of
face value available upon death.
The crux of these problems arise when consumers assume they want to do something
when they have no idea of what the SHOULD be doing. And it invariably happens
not only because of their own lack of research or a preponderance of ego,
but to the perception that the person they are dealing with is competent
to provide the insight to tell them otherwise. In other words, they trusted
someone. NEVER TRUST ANYONE WITH YOUR MONEY UNLESS THEY CAN UTILIZE AN
HP12C AND WHERE YOU HAVE ALSO RECEIVED THE WRITTEN
STATEMENT AS IDENTIFIED UNDER WHO CAN YOU TRUST.
If you are not willing to do some basic homework, plan on getting screwed
sooner or later.