Combat Rising Taxes with Annuity and Insurance Retirement Income

Ten thousand boomers will retire each day for the next 13 years, significantly deepening the gap between the number of retirees receiving government benefits and full-time workers paying into the Social Security program. According to the U.S. Department of Labor’s Bureau of Labor Statistics, there were more than 121 million full-time workers in 2015, and Social Security Administration reports show about half that many people are currently receiving Social Security benefits as retirement income. Given the continuing proliferation of retirees between now and 2030, Doug Endorf’s conclusion is no surprise. The Director of the Congressional Budget Office (CBO), Endorf recently conceded, “Taxes will have to be raised (including the middle class) substantially if we are to have any chance of successfully addressing our budget deficits.”

While this outlook for  the U.S. financial climate may appear grim for your clients, there are strategies to help retirees combat the inevitability of rising taxes when planning for retirement, two of which are reviewed below: annuities and cash value insurance.

Strategy 1: Combining Annuities for Tax Advantages

For clients who have a large amount of taxable assets invested in CDs or sitting in savings accounts, consider using these resources to strategically purchase and combine tax-deferred annuities and immediate lifetime annuities. Deferred and immediate annuities can be important tools for advisors wishing to safeguard their clients’ portfolio in response to a rising tax environment, however careful consideration should be given when choosing the appropriate annuity type.

Some advisors use immediate lifetime annuities as part of a tax deferment strategy for their clients, the idea being the client will be taxed at a lower rate by the time they need to begin making payments.

Tax-deferred annuities, or deferred annuities, are a great option for clients who have already contributed the maximum amount to other retirement accounts but still want to build more retirement savings for future conversion as a retirement income stream. Deferred annuities are good for long-term growth and allow the investor flexibility in investment portfolios, with taxes being deferred until withdrawals begin.

Not only will combining annuities diversify your client’s mix of asset classes, it can provide for several distinct tax advantages:

• Under the regular annuity rules of IRC Section 72(b), lifetime annuities typically offer higher guaranteed withdrawals. This is because lifetime annuities often use an exclusion ratio to treat a larger portion of withdrawal as the tax-free return of principal (up to the age of a client’s life expectancy).
• Depending on the type of tax-deferred annuity (variable, fixed, longevity, equity indexed) that’s best for your client, you may have the ability to reposition, exchange and/or transfer any balance and deferred gains for other opportunities potentially inside the deferred annuity.
• Further reduce your client’s taxable estate with immediate annuities and possibly leverage higher withdrawals in the form of gifts or even by purchasing additional tax-free life insurance.
• Gains from tax deferral are not factored in the calculation of actual tax on Social Security benefits.
• The ability to target a specific period for withdrawal from the deferred annuity in any chosen taxable year.

When considering using annuities to combat a rising tax environment, it’s important for advisors to remember that the type of annuity recommended will depend on the client’s unique retirement income needs.

Strategy 2: Cash Value Life Insurance Tax Exemptions Can Offer Profound  Tax Advantages

“The tax exemption for life insurance is the single biggest benefit in the tax code,” according to retirement tax expert Ed Slott, CPA. During a time when some clients have limited money for savings, retirement and protection, a leveraged product like life insurance can turn one dollar into many tax-free dollars.

Between term life insurance and cash value life insurance — also called “permanent” life insurance — clients tend to know less about cash value than they do term. Both permanent and term life insurance offer a defined death benefit to beneficiaries in the event the insured dies, so long as the policy’s premiums are paid.

The main difference (other than permanent life insurance costing more) is that permanent life insurance includes a cash value component that builds over time. This cash value component can be borrowed against, or it can be used by the insurance company to pay the remaining premiums when the policy becomes “paid up.”

Owning cash value life insurance as part of a complete retirement income strategy is a good way to secure higher long-term returns and more liquidity, while providing a leveraged death benefit. Additional benefits to having cash value life insurance include:

• Increased creditworthiness
• Confidential designation of beneficiaries
• Creditor protection
• Probate avoidance
• Long-term care
• Critical illness and terminally ill benefits prior to death

In the past, using cash value life insurance as part of a strategy to combat rising taxes was a more common practice to help clients get around or pay for estate taxes, but because the government has been raising the estate tax threshold (from $1.5 million in 2004 to $5.43 million in 2015), it has become less widely used. Advisors that limit the potential benefits of permanent life insurance by using it strictly to pay estate taxes, however, may miss providing even more amazing tax benefits to their clients. Cash value life insurance, when treated under IRC section 7702, can provide:

• Death benefit for family as income replacement, or a wealth bequest
• Transfer of a business ownership among other owners, employees or family members
• Charitable bequests
• Liquidity of cash values, including any gains
• No IRS reporting requirements so long as the policy stays within modified endowment limits
• Retirement income generation with the potential to customize policy and reduce major retirement risks including market risk and negative sequence of return risk
• Ability to pledge it as collateral, as opposed to any IRA or defined contribution plan which is normally taxed as a withdrawal when pledged to a lender for a loan
• Easier ability to move death benefit outside the client’s taxable estate
• The ability to reallocate cash values for potentially higher tax-free earnings, depending on the policy type

An advisor’s ability to make the right recommendation regarding annuities and cash value life insurance depends on their overall understanding of the current tax environment, a comprehensive understanding of a client’s needs approaching retirement and beyond, and a deep understanding of investment product options and their benefits.