By Kent Schmidgall, CFP®
Life insurance and annuities can be useful tools, yet like any financial planning strategy, they should only be utilized within the context of your overall financial life plan. This is especially true of their role in a particular, and frequently pitched, wealth-transfer strategy that employs a single-premium immediate annuity (SPIA) in conjunction with life insurance.
The strategy is designed for retirement savers with a large estate and a large IRA account that they won’t need to tap for living expenses. At an essential level, it calls for such individuals to purchase a SPIA inside of their IRA and use the guaranteed income from that SPIA to pay the premiums for a life insurance policy held outside of their estate, typically in an irrevocable life insurance trust (ILIT). Because the life insurance proceeds would, in general, be free of income and estate taxes, the expectation is that retirees could leave a larger legacy than if they only left the IRA to their heirs.
So what’s not to like about that?
For starters, the strategy isn’t universally appropriate. What’s more, it can be misapplied. While properly structured solutions that involve life insurance or an annuity may make sense for some people in some situations, such products are also often among those most popular to pitch. I will walk you through a case study where this particular strategy was proposed, and provide you with some information you may find helpful in determining if it would be right for you.
Some time ago I learned about a couple in their mid-60s we’ll call Homer and Marge who were working with their existing insurance agent to get quotes for long-term care insurance and Medicare supplements. You might naively assume that the insurance agent in question would focus on the task at hand.
But, instead of receiving what they had asked for, Homer and Marge left the insurance agent’s office with numerous proposals, which they suspected may not have been entirely in their best interests, and a big headache.
The agent’s proposal was for Homer to purchase a hefty 20-year period-certain SPIA inside of his IRA, then use the income to purchase a universal life insurance policy on Marge’s life. The policy called for a substantial annual premium, plus an even larger initial lump-sum premium payment in the first year. The expectation was that the life insurance death benefit would grow substantially over time, and Homer and Marge’s children would receive the income-tax-free life insurance proceeds instead of the IRA, pregnant with taxes due.
When reviewing this type of proposal, I think it is good to consider the following higher-level questions before diving into the nuts and bolts:
· Are you prepared to lock in an annuity rate during this period of historically low interest rates?
· Are you comfortable with losing access to a large sum of money?
· Will this strategy negatively impact your ability to meet your retirement spending goals?
There are some additional elements to be mindful of when considering this strategy, and these items may also apply to other situations where life insurance proposals are involved.
Death benefit period: One way for an insurance agent to minimize the proposed life insurance premium is to reduce the guaranteed coverage period. In this particular case study, although the illustrated non-guaranteed values provided a death benefit to age 121, the guaranteed coverage expired when Marge reached age 98. That’s all fine and dandy – until Marge is 97.8 years old.
Guarantees: Because the purpose for this life insurance proposal was legacy planning, rather than using a traditional universal life insurance policy to cover Marge’s life there is a more appropriate product. A no-lapse survivorship universal life (SUL) policy has a contractually guaranteed lifetime death benefit payable upon the second death. Legacy planning should be based on contractual guarantees, not flimsy projections.
Ownership: There was no mention of the policy in our case study being owned by a trust. Although the creation of a trust can lengthen the process of implementing this strategy, ownership by an insurance trust should be considered. Doing so would not only keep the insurance proceeds outside of Homer and Marge’s estate, should it ever exceed the federal estate tax exemption limit, it may also provide creditor protection and clarity in distributing the insurance proceeds.
If you don’t want to potentially jeopardize your retirement lifestyle in order to leave a legacy, there are simpler alternatives to consider:
Roth conversions: By executing partial Roth conversions over time, your heirs would receive a tax-free Roth IRA instead of a traditional IRA on which taxes would be owed. In addition, you would still have access to the funds in the Roth IRA.
Scrap the annuity: If utilizing a life insurance policy is the best way to meet your legacy planning goals, rather than lose control of a large sum of money by purchasing an annuity, you could simply pay the ongoing life insurance premium from cash flow or by liquidating investments. Sure, it isn’t tax-efficient to withdraw IRA funds to pay life insurance premiums, but this would at least reduce the odds that down the road you would be required to pick up a side job as a bouncer at your local watering hole just to make ends meet.
Dynamic approach: Another approach is to also factor your legacy planning goals into a Monte Carlo simulation. You would then periodically analyze the outcomes and adjust the plan accordingly. For example, you may be required to lower your retirement spending a bit or work a little longer to increase the chances of funding a legacy goal.
Although life insurance and annuities can be effective in certain circumstances, they should only be considered within the context of your larger financial and life plan. Understanding the variables in play can help you avoid some common pitfalls that could threaten your financial future or that of your heirs.
About the author: Kent Schmidgall, CFP®
Kent Schmidgall, CFP®, is a Wealth Advisor with Buckingham Strategic Wealth. He resides in southeast Iowa with his wife and three children. His perfect day includes a steaming cup of coffee, a warm fire, and a Dickens novel.
Important Disclosure: Case study is for illustrative purposes only and does not reflect an actual client’s experience. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting, tax or insurance-related advice. IRN-20-1484