I met an older gentleman, Charlie, about a month ago whose wife passed away a few years ago. He is managing assets mostly for his three children but is keeping the same investment philosophy going forward. He wants to minimize risk and taxes. His major concern is that with the newly proposed ‘American Families Plan’ a major key tax benefit for inheritance could be taken away.
For years one of the best ways to pass assets to the next generation was with highly appreciated stocks. If you bought a stock at $10 and died when it was worth $20, your family gets a stepped-up basis to the current price. If sold by your heirs they will pay no capital gains tax. Had you sold it before you died you would have been liable for a $10 capital gain. It has been a pretty big advantage for anyone who held stocks for several decades.
Well that could all be going away now that there’s a lot of federal spending that congress needs to pretend to pay for. In fairness it only applies to large accounts over $1M, at least as the proposed law is written. But these things tend to have a way of creeping up to include everyone regardless of assets so all of you should pay attention.
When the 16th amendment to the constitution was passed to allow for income taxes, it only applied to people making more than $4000 per year. That was 1913 and no one paid attention to it because that was more money than the average person could ever dream to make. Over time personal income rose exponentially more than the standard exclusion. Draw your own conclusion on that.
Charlie doesn’t need any of his investment money. Pensions and social security cover all his needs and all insurance is in place for any emergencies that may arise. The stock market is high and he doesn’t want risk, plus he might lose the tax benefit when passing to his heirs. He wanted to see if annuities would be a viable alternative.
Last week I talked about how variable annuities protect the base investment for heirs in case of untimely market volatility. Now I’m going to explain how annuities in general work as an inheritance tool. First let me state that there is no magic advantage to annuities and this is not about product features like death benefit enhancements. It’s simply an explanation of how the law states an annuity can be passed to the next generation
Also I need to disclaim that none of this applies to a spouse. With any annuity there is an unlimited spousal transfer. Upon death your spouse can either exercise the specified death benefit or keep the contract as their own. The following only applies to the next generation or anyone who is not a spouse.
The source of the money used to buy the annuity is the first key. Qualified money is pre-tax and comes from accounts such as 401(k), 403(b), TSP, Traditional IRA etc. If any of those accounts is used to purchase an annuity then the annuity would be qualified as a Traditional IRA. If your annuity is an IRA then when you pass away, inheritance is dictated according to IRS rules for inherited IRAs. Congress already jacked this one up a couple years ago and now options are more limited.
With an inherited IRA annuity your heirs have the choice to take the balance of the account out within 10 years of the date of death. It can be done as a lump sum at any time or via systematic payments over ten years or the beneficiary can even wait until the very last day of the tenth year and take it all out at one time. The big thing is that the stretch IRA was eliminated, which allowed beneficiaries to slowly liquidate an IRA over their own life expectancy, thus reducing the tax burden for the next generation. But the Feds weren’t making enough money on that so they changed it. Long story short: If you have an IRA-qualified annuity then it is more IRA than annuity when it comes time to pass it to your heirs.
Non-qualified funds are post-tax, like money in a savings, checking, money market or brokerage account. If you purchase an annuity with post-tax funds then it’s typically done by writing a check or executing a wire transfer to the insurance company. The basis in any non-qualified annuity will be returned tax-free to your heirs but the gain is taxed as ordinary income. This is where your heirs have options.
Your heirs could take a lump sum and pay all taxes upfront, or they can take equal payments over five years to reduce a big tax bill, or they can stretch payments over their life expectancy to further reduce the tax burden. Each payment would have an exclusion ratio with a portion of tax-free basis and taxable gain. Because of this feature there are many deferred annuities that have lasted for several generations.
Let’s look at a quick example to illustrate the benefit. Charlie has three kids who will be equal primary beneficiaries. When Charlie passes away, the annuity contract would avoid probate and pay directly to the kids who would each inherit an equal share. Each beneficiary can elect a different choice. One could take his share via lump sum to buy a house. Another who may be in a higher tax bracket can choose to stretch his payments over life expectancy. The third one might want to delay social security could take equal payments over five years while using the annuity proceeds to pay retirement expenses.
This all assumes three individual situations for Charlie’s kids which I don’t know but the idea is to illustrate the ways an annuity can be used. Anyone who takes the stretch option can exit that strategy and take a lump sum at any time. For those who have a hard time making decisions I usually recommend the stretch option because they can later revert to either of the other two options. There is no major tax benefit to annuities as an inheritance tool but there is a fair bit of flexibility for heirs of anyone who purchases an annuity with non-qualified assets.
I focus on strategies that help people make more money with annuities. Therefore, people who work with me will likely have money left in an annuity after passing. Everyone should know and be able to plan how to deal with it. If anyone wants to specifically address their situation I am available to personalize this information so you take comfort knowing how an annuity will benefit the people you care about most.
Enjoy your weekend!