Finding Certainty in Uncertain Times

In 2008, many people suffered terrible losses in the stock market and real estate investments. Money market accounts and Certificates of Deposit offer safety, but typically pay less than 1 percent on a short term basis.

What if there was a way to get a yield of 6 percent or more for the rest of your life, save estate taxes, and provide for your family and/or your favorite charity? Would that be of interest? Well, it can be, and has been, done very effectively in many financial and estate plans.

The insurance industry has an asset known as a single premium immediate annuity. It guarantees an income for life and the older you are, the higher the yield. For example, one client, a 62-year-old man, got a guaranteed 7.9 percent yield, 66 percent of which is income tax-free (as a return of principal) for 17 years. An 80-year-old female got a 13 percent yield, of which 80 percent is income tax free for approximately 11 years.

This sounds great, but what is the catch? What is an investor missing? One main disadvantage is that, should the investor die, the asset goes away and the income stops. So, how do you solve that problem?

There needs to be a replacement asset to offset the loss of the annuity, and that can be accomplished effectively with life insurance. For the 62-year-old male, the cost of insurance was 2 percent of the investment; for the 80-year-old female, the cost of insurance was 5 percent. This means the net yield for the 62-year-old male was 6 percent (8 percent minus 2 percent) and for the 80-year-old female, it was 8 percent (13 percent minus 5 percent). These are very good yields in any environment, and they are guaranteed by the insurance company.

So, how does this work for an estate plan or for a charitable plan? First, from an estate planning point of view, if an individual invests $1 million into the annuity and the annuity goes away at death, that saves approximately $450,000 on estate taxes (45 percent tax rate for taxable estates above $2.5 million). The insurance replacement asset is structured to be owned by the children or an irrevocable trust so as to be estate tax-free at the time of death. The net result is a higher guaranteed yield from the insurance company during the investor’s lifetime, much of which is income tax-free, and asset replacement at the investor’s death on an estate tax-free basis.

This investment strategy can also be used for an investor’s favorite charity. The asset would be donated to the charity, which would use the gift to purchase an annuity and the life insurance. The annuity payments would be used to pay the premium on the insurance and to provide the donor a lifetime return. The charity would recover the insurance proceeds at the donor’s death. For example, a $1 million donation generates $60,000 a year to the 62-year-old, and $80,000 a year to the 80-year-old, net of insurance costs. (These yields can vary depending on the age and health of the donor, and prevailing insurance and annuity rates).

It is very difficult in these uncertain times to find certain returns, but this strategy creates a great win-win result for the investor, the estate plan, and the charitable plan.

Norman Pappas is president and founder of Pappas Financial and the author of several articles on business and estate planning topics. His book, Passing the Bucks, is a guide to business succession and wealth transfer planning. He can be reached at [email protected].