We spend most of our lives working hard and saving for retirement. But what happens if you are fortunate enough to not need all your savings and investments to live out and enjoy your ideal retirement? There are certainly many planning options to consider. One we will discuss in this article centers around non-qualified tax deferred assets. If you are looking for a tax efficient way to gift your nonqualified assets and would like your beneficiaries to be able enjoy that gift, consider the following strategy involving variable annuities. This strategy may also help to decrease your total estate value if you are within federal estate tax territory.
When gifting an annuity, unfortunately, tax law dictates that you must pay taxes on all the gains if you gift an annuity while it is in the accumulation phase. Also, annuities do not receive a step-up in tax basis at death, which means beneficiaries are on the hook for taxes on all the growth. Upon death, a beneficiary of an annuity still in the accumulation phase has the option of taking a lump sum and paying taxes on the gains all at once or taking withdrawals over a 5-year period to spread out the tax burden.
However, if an annuity contract moves from the accumulation phase to the payout phase before it is gifted, one would not owe taxes on the gain, and the person(s) to whom you gift the annuity will receive a tax-efficient lifetime income stream that keeps him/her in control of the contract, including the ability to take additional withdrawals. That person(s) will pay regular income taxes only on the portion of gain in each payment, rather than as a lump sum. This exclusion ratio means they get a portion of the non-taxable principal back with each payment. They also can take out any remaining cost basis (nontaxable principal) in a lump sum after the death of the annuitant and still receive monthly payments for their life on the taxable portion of the annuity.
Let’s look at an example:
Joe Smith has a $1,000,000 variable annuity investment still in the accumulation/growth phase.
Jane Smith has a $1,000,000 variable annuity investment still in the accumulation/growth phase.
They do not need these assets during their lifetime and plan on leaving these assets to their 2 children, Sam and Sue.
Joe and Jane can each transfer their policies tax free, and once transferred, they can add a rider that allows for special tax treatment. Joe would add Sam as the annuitant on his contract, and Jane would add Sue as the annuitant on her contract.
As soon as the rider is added to the contracts, the policies are moved from the accumulation phase to the payout or annuitization phase. One monthly annuity payment is then paid to Joe from his policy, and one monthly annuity payment is paid to Jane from her policy.
After that first payment to Joe and Jane is complete, they can change the ownership on the annuity policies. Joe changes the ownership of his policy to Sam, and Jane changes the ownership of her policy to Sue. Joe and Jane owe no taxes after the first annuity payments, and Sam and Sue receive a lifetime income stream where they pay income tax only on the portion of gain in each payment.
Once ownership is transferred, another benefit is the Smith’s now have removed a total of $2 million from their estate. It is important to note that this gift transfer does count against the federal estate tax exclusion amount.
All of this is meant to educate you on a possible planning tool. It is also important to note that this rider is not available with every annuity company. It is imperative to discuss this tactic with your tax professional, attorney and financial planning professionals to comprehensively evaluate your individual situation and determine if this strategy is a viable option for you. As always, we at Fragasso are here to help answer any questions and facilitate the conversation with your tax professional and attorney.