Even When You’re Dead
As I sent off my 2004 tax audit paperwork, I ran across a little article explaining the consequences of owning an annuity when you die. It’s not that this is news to me, I’ve known about the consequences to the heir for some time. It just reminded me about estate taxes and how offensive I find them.
I like to call estate tax what it really is, Death Tax. It’s what the government charges you for dying in this Country–their final hurrah as you go into the afterlife or just into the ground depending on your beliefs.
If you own an annuity when you die, its value is naturally included in your estate. However, the heir may not be able to cash out the annuity or a portion to pay estate taxes with. You can see, it is possible to create a serious tax problem for an heir. On top of this problem, the heir’s gains are generally taxed as normal income to the heir rather than as capital gains meaning they could be in a higher tax bracket.
If your clients have annuities then you might want to bring them in to analyze the potential impact of the annuity on the estate. You can mitigate some of the problem by adding life insurance to pay the taxes. But don’t be too shocked if you end up having to change the strategy all together. It’s really a shame that annuities have these estate tax problems; they provide a great sense of security for an elderly couple needing an income stream.
On the plus side there is another creative use of annuities that I have seen–funding them for minors. Here’s the situation… Joe and Sally client are planning on Junior going to college. They start an account for Junior at Big Funds Group, Inc. and religiously put money into the account. At 14, Junior starts paying taxes on the account so he knows it’s there. At 18 or 21 (depending on the age of majority in Joe and Sally Client’s state of residence) the account with $150k belongs to Junior.
There are three possible outcomes here:
- Junior is very responsible goes to college and gets his education.
- Junior does not go to college, he decides to tour with the Grateful Dead (or their modern equivalent). Why not he has 150k in the bank to have fun with.
- Junior goes to college joins a frat and parties like an animal for two years, runs out of money and comes home.
I would put number 1 at about a 1 in 5 chance at best. This is where there the creative use of an annuity can come in. If Joe and Sally had funded a variable annuity instead, junior would have no idea the account was there. No tax returns being filed or anything to give it away. Sure junior still has the 150k but junior has no idea he has it.
When Junior goes off to college, Joe and Sally pull money out of the annuity to fund it and Junior pays income tax on it. If Junior decides to go tour with the Dead he has no idea the money is there. If Junior drops out, same concept applies. When they feel Junior is mature enough, Joe and Sally can tell him about the annuity. If Junior decides not to go to college at the very least he has a great start on retirement savings.
Matt Abar said,
March 15, 2007 at 6:55 pm
Strongly disagree. I look at Estate Tax from the perspective of… How many generations of Grateful Dead-touring Juniors should US taxpayers be willing to fund? Do we really want to create an aristocracy of trust-fund kids that don’t have to work for a living? Not only do I think the estate tax should be *higher*, I think there should be limits put on the amount that can be passed to others through trusts.
I do think some changes need to be made. The $1.5 million cap should be raised to about $5 million and tied to inflation. This will make it possible for small family businesses and reasonably-sized homes to be passed to the next generation, which is a legitimate problem. I also think the estate tax should be progressive, similar to the normal income tax brackets. 15% on the first $10 million, 25% on the next $25 million, etc. The 50% bracket wouldn’t kick in until $100 million or so.
I’d also like to keep the current cap gains tax low if not go lower. Yes, the Estate Tax is a death tax, but if I have to pay taxes, I’d rather pay them when I’m dead.
I realize there’s a deeper level of understanding that I’m not taking into consideration. I know there’s a certain level of estate tax that starts driving money out of the country and into charities. But this is what my gut says.
Bill Ramsay said,
March 28, 2007 at 12:07 pm
It would only take 2 or 3 generations to have a true aristocracy if estate taxes were eliminated. Highly skilled investment advisors, attorneys and cpa’s would help families setup and manage family corporations that could live indefinitely. The trustafarian population would indeed swell.
I wonder if we’d start using terms like Lord or Baron?
I believe we’ll actually end up settling somewhere around 2.5-3.5 million per person with inflation adjustments. That’s about where a majority of voters would say “really rich” begins.
As for college funding, it is important to try not to have a UTMA account get too big, we’ve had a couple of problematic cases like Mike mentioned, but an annuity should not be part of the planning (due to the age 59 1/2 restrictions, excessive costs, ordinary income tax treatment on earnings and the negative inheritance issues). A 529 will accomplish the goal of tax advantaged savings without being required to give the money to children if not appropriate. We also have many clients where we don’t have them set aside any money specifically for college, since we want them to fully fund the best tax advantaged accounts- Roths and 401ks. They can then use the Roths, up to the total contributions if need be for college, or simply cut back their savings while children are in college and pay for it at least partially from cash flow.