Clients often ask me about the role of their annuities in legacy planning. There is a wide range of options available for creating an annuity, including some with death benefits, so it is important to understand how these benefits work—and how they compare to the options available with life insurance.

Annuities and life insurance have complementary, rather than overlapping, roles in your financial life. An annuity is a form of insurance with the goal of paying out to the annuitant, rather than their heirs, while life insurance is designed with legacy planning in mind. Therefore, they should be structured in conjunction with each other. Given the complexity of both products, a trusted financial advisor can be of great assistance here. Below, we will explore some of the functions of life insurance vs annuity death benefits in more detail and see how each of them contributes to future wealth transfer.

Choosing an Annuity Death Benefit

The focus of this discussion is not on the death benefits of fixed indexed or fixed rate and term annuities that allow you to keep your principal intact. For this discussion, we are focused on immediate income and deferred income annuities that you purchase to provide ongoing income at the expense of surrendering control and access to the principal.

In this instance, an annuity is most often used as a component of retirement planning. It can be set up with or without a death benefit for your heirs. Options for structuring your annuity include:life insurance and annuities for wealth transfer

  • Lifetime payment annuities: This option guarantees payment for the entirety of your life, with no benefits for heirs. The size of the payout depends on your life expectancy. If you die earlier than expected, the balance of the money you paid into your account does not go to your heirs. If you live longer than expected, however, you continue to receive payments beyond the amount you invested in the annuity, thereby impacting the rate of return considerably.
  • Period certain annuities: With this benefit option, you receive a set amount for a set time. If you die before the end of that period, the payments are transferred to a beneficiary.This often provides much more income compared to a life annuity option.
  • Lifetime payment with a period certain: A combination of the two annuity benefit options above, this offers a limited period during which your heirs will receive payments in the event of your death. Once the period certain is past, you will continue to receive lifetime income for as long as you live.
  • Survivor or Joint and Survivor annuities : Your spouse will receive benefits for the rest of their life after you die. This is commonly used when trying to provide income for the duration of both lives.a spouse is the beneficiary.

Your choice of annuity death benefits will depend on a variety of factors, including your income needs and your legacy planning goals, as well as the other investments and financial instruments you possess. Expert guidance can help you make the optimal selection for your family’s needs.

Annuities, Life Insurance, and Taxes When Considering Death Benefits

An annuity can be paid for with pre-tax money, in which case it is referred to as a qualified annuity, or it can be paid after taxes, i.e. a non-qualified annuity. In either case, the annuity will grow and that growth is not taxed before the payout. In this regard, an annuity resembles an IRA. There is an assumption that you will have a lower income at the time you begin receiving annuity payments, in comparison to the time when you pay for the annuity, and so it is more advantageous to pay the tax bill at the time of payout.

There is an assumption that you will have a lower income at the time you begin receiving annuity payments, in comparison to the time when you pay for the annuity, and so it is more advantageous to pay the tax bill at the time of payout.

An annuity always contains some element of taxable income, though, whether it is tax on any amount above the entire sum of your investment at the time of payout or only the growth of the principal when distributions occur. Under current tax law annuities are taxed on a last in/first out basis (LIFO). The assumption is that the interest is paid out first, which is taxable as ordinary income, then your principal is paid out which is not taxable. That means that since only part of the payout is taxable, there will be an “exclusion ratio” until such time as you have gotten all of your earnings and principal and then continue to receive income .

At that point, all of the income becomes taxable since none of that is your money. If there is money available to your beneficiaries under your chosen annuity option, they will be liable for the unpaid taxes. In addition, annuity death benefits may be subject to inheritance tax depending on your state.

If there is money available to your beneficiaries under your chosen annuity option, they will be liable for the unpaid taxes.

This is in contrast to life insurance, which is always income tax-free and which can be structured so that it is sheltered from estate taxes with the use of an irrevocable life insurance trust (ILIT). For these reasons, life insurance has a significant advantage over annuities for wealth transfer when established with the help of a financial advisor and should be used in preference to the annuity death benefit.

Life Insurance vs Annuity Death Benefits

Although annuities are subject to taxes, it doesn’t mean you don’t need an annuity as the value of annuities is obtained while you are alive. If you set up an annuity that guarantees you an income for life, you free up other money that can be used for wealth creation. An annuity also protects your assets in this way, since it removes the need to monetize them for retirement purposes.

If you set up an annuity that guarantees you an income for life, you free up other money that can be used for wealth creation.

This is especially significant when you create an ILIT. Your life insurance benefits are transferred irrevocably to that trust, removing any chance of accessing that money again without considerable complexity and expense. Lifetime income annuities can also be structured to pay an annual premium on a large life insurance policy to guarantee a large future tax free death benefit worth much more than the annuity proceeds would ever be worth. Once death occurs, the claim is settled and no more income is payable.

If you have other sources of retirement income, annuities can still be used as a safety net in retirement to guard against the expenses of unforeseen medical needs or long-term care, or as a back-up financial plan in case you use up your IRA, 401(k), and pension funds. However, the bulk of your estate can be more efficiently transferred to your heirs through life insurance.

At Howard Kaye Insurance, we can help you structure your annuities and life insurance policies to balance your income needs in retirement with your legacy planning goals. We can help create strategies to provide retirement income, protect your assets, and minimize your tax bill. For more information, contact a Howard Kaye advisor today at 800-DIE-RICH.

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