Financial advisors have been endlessly creative – sometimes to a fault – with using life insurance and annuities to create planning strategies with the goal of maximizing estate values and minimizing taxes.

The truth is there are several ways insurance and annuities can be an effective part of a financial plan. Used correctly and with foresight, they can help clients create a more secure retirement and rewarding legacy.

Let’s look at a few:

 

Cover The Costs

When interest rates on bonds rise from today's low levels (a sure thing, but no one knows when), you might consider a tactic of Ben Baldwin, author of the New Life Insurance Investment Advisor (McGraw Hill Professional). He has the client invest enough in the policy’s bond fund or fixed account to cover the cost of the insurance. Then he invests the rest in the policy’s stock funds for growth.

Hypothetically, say your middle age male client pays about $1.25 per $1,000 of insurance coverage for a $500,000 life insurance policy. The annual insurance charge runs about $625. As a result, your client would need to invest about $12,500 in a bond fund to cover that cost, assuming the fund yields 5% annually.

But be warned: If the policy is funded too rapidly, your clients risk running afoul of the “seven-pay” test – the limit on the amount of money a client can pay into their policy in the first seven years. If exceeded, it could result in the policy being considered a “Modified Endowment Contract” by the IRS, which was established to curb the use of life insurance to escape taxes. If so, pre-death distributions can be subject to taxes and penalties.

 

1035 Exchange

Howard Kaye, a Boca Raton, FL-based insurance agent who deals with wealthy clients suggests deferred annuity policyholders fat with cash can do a 1035 exchange into a single premium immediate annuity with a single life payout. The policyholder then uses the annuity income to fund a life insurance policy. This allows more money to be left to loved ones, compared with the deferred annuity.

Kaye also suggests a strategy to bulk up assets and reduce taxes for well-heeled clients with a few million dollars in an IRA rollover account. Here’s how it works:  The retiree takes the first-year IRA distribution to buy a multimillion-dollar life insurance policy on his or her spouse. When the spouse dies, more money can pass to that spouse’s beneficiaries or charity. Meanwhile, the remaining money in the IRA continues to grow tax-deferred. The next step may be to set up a private foundation, or other philanthropic vehicle, so that so that the proceeds from the IRA go to a charity tax-free.

 

Avoiding The Tax Time Bomb

Ken Nuss, CEO of AnnuityAdvantage.com, warns that your clients could be sitting on a tax time bomb if they have owned a deferred annuity for a long time. Reason: Loved ones who inherit a deferred annuity don’t get a step-up in tax basis like they would if they inherited stocks or bonds outside of an annuity. So if a client plans to keep rolling over a deferred annuity for years, he or she may be better off cashing it out, paying taxes and investing the rest in a life insurance policy. This way, death benefits go to the beneficiary tax-free.

Peter Bono, an insurance agent who deals with wealthy Palm Beach, FL residents, often puts life insurance in trusts. He sets up a universal life insurance policy so policyholders pay a single premium or level payments for pure insurance protection.

An insurance company’s “Guaranteed Death Benefit Universal Life” policy, he notes, has no cash value or savings account so it minimizes premiums.

“The trust owns the policy to keep it out of the estate,” Bono says. “You want to pay as small a premium as possible. So you set up a minimum premium that will guarantee coverage for life.”