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[Deferred annuities are powerful financial instruments; however, a long-standing debate among financial commentators involves the respective advantages of deferred annuities versus individual equity portfolios or mutual funds. Many (like Jane Bryant Quinn) have concluded that annuities are a bad buy. Is that a valid assessment? Let's see.] Testing Financial Tolerance For Tax Deferred Annuities (Part 1) Case Study Background: The analysis that follows involves a couple, ages 45 and 40, who expect to have a $1,000,000 inheritance released from Probate shortly. They are deciding whether to invest it in an equity-based tax deferred account (e.g., a variable annuity) or a custom-designed equity portfolio. For comparison purposes, they assume that both accounts will have the same yield, and both will experience portfolio turnover of 35% a year. The likely portfolio turnover makes the tax deferred account attractive since there is no ongoing tax associated with such turnover, whereas turnover will retard the growth of the equity portfolio due to the capital gains taxes generated. On the other hand, the death taxes on the tax deferred account are much more severe. We will analyze the effect of the alternatives both on living Net Worth and Wealth to Heirs as well as quantify the precise difference between the two alternatives. This couple's current Net Worth is a little over $1,300,000, and you can review the breakdown by clicking here. (The Client Information Summary lists their assets before accounting for the $1,000,000 inheritance.) They expect to add $10,000 a year to their 401(k) plan, $5,000 a year to their taxable accounts, $5,000 a year to their tax exempt account, and $15,000 a year to their current equity portfolio. They plan to retire in 20 years, and want after tax retirement income of $125,000 in today's dollars assuming 3% inflation a year. This means their first year's retirement income must be $225,764 and, should they live to age 95/90, their Net Worth must be able to support $10,740,810 in cumulative after tax retirement income. Below is an InsGift graphic of the Net Worth comparison. Strategy 1 above reflects Net Worth if the $1,000,000 inheritance is placed in an equity portfolio at 10% (9% growth and 1% dividend); Strategy 2 above shows the results if the $1,000,000 is invested in the tax deferred account at 10%. (It is assumed that the death benefit guarantee option on the tax deferred account has not been purchased.) As you can readily see, Strategy 2 -- the tax deferred account -- is the clear winner. At death, however, an equity portfolio does not suffer the severe taxation visited upon a tax deferred account. The cost basis of the tax deferred account is subject to estate tax, and its growth is taxed like an IRA, i.e., subject to both income and estate taxes. Even so, at death, the estate with the tax deferred account outperforms the estate with the custom-designed equity portfolio -- as the InsGift graphic below shows:
Conclusion? For those who would rather have more value while alive and bequeath more value to heirs, acquire the tax deferred account. Note: This analysis is highly sensitive to the portfolio turnover assumption assigned to the equity portfolio. Further, in this study, no retirement cash flow funds are needed from the tax deferred account as other assets and benefits were sufficient to provide the needed retirement income. For cases in which income from the tax deferred account is needed, it will be a less efficient source for that cash flow (due to the income tax on withdrawals). Because of this, a tax deferred account should be one of the last sources of any needed cash flow (which the software used to prepare the graph can accommodate). Illustration Comments: We used version 5.0 of InsGift -- the Wealthy and Wise System ("InsGift") for the analysis, and InsGift licensees can review all reports and related menu inputs for the estate analysis by selecting the InsGift Workbook named "MA121122.!IG" from this website. Click on Producer's Center; then on Workbook Download. Review only the first three scenarios and the first Comparison. The fourth scenario and the second comparison apply to the next article in this series, Testing Financial Tolerance for Tax Deferred Annuities (Part 2). Click here to download the workbook now. In case you are not licensed for InsGift, you can access a list of all the features of version 5.0 of InsGift by clicking here. Be sure to take a few minutes to look it over -- we think it shows impressive capacity. With the new IRS attack on split dollar, InsGift may be a production lifesaver for you. If you are not licensed for InsGift, please contact InsMark at 1-888-InsMark (467-6275) for licensing information, or click here. Note: In Part 2 of Testing Financial Tolerance for Tax Deferred Annuities, we will augment the analysis in this article to include a compelling life insurance sale. Note: Version 5.0 of InsGift can also illustrate annuity 1035 exchanges as well as show the effect of bonus interest credits. To illustrate a 1035 exchange, do one scenario with the current annuity scheduled under Liquid Assets. In a second scenario, replace the current annuity with the proposed annuity -- including any bonus interest due on the exchange. |
