June 2011 Newsletter | Indexed Annuities, Planning for Pets

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In This Issue:1. ANNUITY TRAPS


Last month, we began a discussion of annuities. Specifically, the traps people fall into because they or their adviser don’t fully understand how annuities work. An annuity is an insurance product sold by financial institutions and is designed to grow funds, tax-deferred, until the money is withdrawn. Last month, we discussed living benefits and the problems that can be created while the owner of the contract is alive. This month, we will focus on problems that can crop up once the owner of the contract dies.

Annuity Traps Part II – Death Benefits

Let’s start with some definitions. There are three parties to every annuity contract – the owner, the annuitant, and the beneficiary.

The owner controls the contract. The owner has the right to add and withdraw money, change parties to the annuity and terminate the contract.

The annuitant is similar to the insured in a life insurance policy. The annuitant, unless he or she is the contract owner, has no say in or control of the annuity contract. The annuitant does not have the power to make withdrawals, deposits, change the names of the parties to the agreement, or terminate the contract. The only qualification is that the named annuitant is a person currently living who is under a certain age. The maximum age of the proposed annuitant depends on the insurance company. Most annuities allow the contract owner to change the annuitant at any time. The annuitant is the individual named under the annuity contract whose life will serve as the measuring life for purposes of determining benefits to be paid out under the contract. According to the Internal Revenue Code, the annuitant is the individual whose life is of primary importance in affecting the timing or amount of the payout under the contract. The annuitant and the owner can be one and the same.

The beneficiary is like the beneficiary of a life insurance policy. The death benefits of the annuity contract are paid to the beneficiary when another party to the annuity contract dies. The beneficiary has no rights under the annuity contract, other than the right to receive payment of the death benefit. Likewise, the beneficiary cannot change the payout settlement option, alter the starting date for benefit payments, and cannot make any withdrawals or partial surrenders against the contract.

According to the Internal Revenue Code, the death benefits of an annuity contract are triggered upon the death of the owner. If the contract has joint owners, the annuity is still required to begin making distributions upon the death of any owner. We often find annuities held jointly between husband and wife with the children named as beneficiary. When one of the spouses dies, the proceeds of the contract are paid out to the children. In nearly every case I’ve seen, this is not the intention of the parents. It is extremely important that you make sure your annuity contracts are titled properly. If the design is for the annuity to benefit a surviving spouse, then one spouse should be named owner and annuitant and the other named as beneficiary. The children can be named as contingent beneficiary in the event both spouses die at the same time.

The Five-Year Rule

Distributions at death must be completed by the fifth anniversary of the date-of-death of the owner. This is similar to the IRA distribution rule at death with the important exception that the five years begins with the date-of-death. IRA beneficiaries have five years beginning from December 31st of the year that death occurs. The proceeds can be distributed in any fashion during the five year period. For tax purposes, distributions are considered earnings first and principal last. The earnings will be taxed to the beneficiary as ordinary income.

There are two exceptions to the five-year rule:

1) The beneficiary has the option of taking the distributions equally over their life expectancy. In order to be able to elect this option, the beneficiary must be named in the contract. They cannot be assigned as beneficiary by the executor. When the beneficiary chooses this option the payments are considered part principal and part earnings for tax purposes. The actual ratio is calculated based on the principal in the contract divided by the number of expected payments. The payments must begin within one year of the date-of-death and the beneficiary must be a person; not an entity. If a trust is named as the beneficiary, it must follow the five-year rule.

2) When the named beneficiary is the spouse of the deceased owner, they can elect to continue the contract without taking distributions. Essentially, they take control of the contract as if they were the owner. Some insurance companies have restrictions on the amount of control the spouse can exercise if they choose to continue the contract in force. You should check the terms of the contract to determine what restrictions may apply. This election can only be made when the spouse is the named beneficiary in the contract. When the spouse beneficiary dies, the normal rules for distributions to the contingent beneficiary will apply. The IRS has made private letter rulings allowing spousal continuation of annuities when the spouse’s revocable living trust has been named as the beneficiary.

Deductions for Estate Tax

The entire value of the contract is included in the estate of the deceased and may be subject to federal estate tax. The deferred earnings in the contract are taxable to the beneficiary as ordinary income. The beneficiary is entitled to deduct the amount of estate tax paid on the contract from his tax return to avoid double taxation. This deduction is known as Income in Respect of a Decedent and is probably one of the most frequently missed deductions. Keep in mind that this only applies to federal estate tax and not state inheritance tax. Furthermore, estates are currently only subject to estate tax when they exceed $5 million.

Annuities at death are like other types of retirement accounts in that all of the deferred income is passed on to the beneficiary and will be taxable when withdrawn. There is one exception. Annuity contracts that were issued before October 21, 1979 and are still in force at the death of the owner get a stepped up cost basis. This means the beneficiary will receive all the earnings tax free. This is a rare situation, but one to be aware of before cashing in an old policy.


Annuities may be an important tool for building wealth but they are not for everybody. While they are very similar to IRAs and other types of retirement accounts, annuities have a unique tax structure of their own. Individual insurance companies often have unique rules for their specific contracts which complicate the situation even more. Make sure you have all the information before you purchase a contract. Each individual’s circumstances are different and there are no pat answers. If you already own an annuity, have it reviewed by a financial planner who understands the issues regarding annuities and make sure you have your contract titled properly. Many problems can be addressed and remedied while the contract owner is still living.

See our newest blog postings from Rick, Lee, Mike and Alan


After the turmoil of the 2008 stock market, who could resist the offer of capturing the upside of a market with no downside risk? Sound too good to be true? That’s basically how equity indexed annuities are being positioned by some issuers. They promise that you will never lose money when the stock market declines and that you will still be able to participate when the market goes up. What’s not to like? Let’s look at the facts.

Although the name says equity index, you don’t actually invest your money in the stock market. Your return is based on a market index like the S&P 500, but you don’t earn any of the dividends. Dividends are an important part of the stock market return. The 20 year average for the S&P 500 Index for the period ending April 30, 2011 was 8.86%. However, if you take out the dividends the return drops to 6.66%. By giving up dividends you gave up nearly 25% of the total return of the market.

Another important limitation is the capping of returns. Many equity indexed annuities allow you to participate in the return of the index up to a point. Some contracts cap the return at 7 or 8%. Others reduce your return by offering you a participation rate. This rate is quoted as a percentage of the index return (without dividends) and is typically 70% to 80% of the index. Not only do you miss out on dividends which could be 25% of the return, you take another 20-30% cut through the participation rate.

Finally, the equity indexed annuities I’ve reviewed all had large penalties for early surrender and 7-10 year or more holding periods until you can cash out. This is a fairly hefty price to pay for peace of mind, especially when you can accomplish the same thing without subjecting your money to early withdrawal penalties.

Consider this example: If you had $100,000 to invest, you could buy a 10-year treasury note to guarantee your principal. As of mid-May 2011 the note was yielding 3 ½% so you would need to invest $70,892 in the note so it will grow to $100,000 in 10 years. The balance of $29,108 can be invested in an index fund. Using the 20 year average index return of 8.86%, the $29,108 grows to $68,000 in 10 years and the bond grows to $100,000 for a total return of $168,000. That works out to an average annual return of 5.32% .Assuming the same 20 year average return, if your equity indexed annuity gave you 70% of the index return without dividends for the same 10 years, it would have produced an annual yield of 4.66%.

There’s more. While the earnings on your annuity would have been tax-deferred for the entire time, it would all be taxed as ordinary income when it comes out. If it were in a mutual fund, the growth would be taxed as dividends and long-term capital gains so a taxpayer in the 15% bracket would be taxed at zero on these earnings. Taxpayers in higher brackets would be taxed at a maximum of 15% tax on those earnings versus a maximum of 35% on ordinary income.

The tax difference is an important consideration, and as you can see, this is complicated. There is no free lunch. Insurance companies need to be paid for taking risk. It’s up to you to determine if the guarantees are worth the price.

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My grandmother had a lovable toy poodle she named Bopper. Bopper was her constant companion during the later years of her life. When my grandmother passed away, there were no instructions for the family regarding Bopper. Who was to care for him?

Sad but true, we plan for everything in our lives but often fail to plan for our pets.

Some clients make plans for their pets but fail to keep them up to date. I remember reading about a significant bequest of money that was left to care for a dog; unfortunately, the dog had been dead for a number of years.

I am not a pet person, so I hadn’t given pet planning much thought until I became a boater. This might sound strange unless you understand that most boaters I’ve met are dog owners. In fact, their dogs are more like members of the family. It only stands to reason that you should put some thought to planning how this member of the family would be taken care of in the event of your death or disability.

Select a caretaker – Bopper created tension in the family as several members thought they should be the one to take care of him after my grandmother’s death. You should consider creating a pet card (with a photo) identifying the pet and naming a caretaker in the event of your death or if you become incapacitated.

Provide instructions – The caretaker should be given appropriate information about the care and feeding, medications, emotional needs and behavioral issues.

Write a living will (for the pet) – This document works the same as an Advanced Healthcare Directive. It will provide instructions for the veterinarian as to how far he/she should go to keep a pet alive in the case of serious injury or illness.

Durable power of attorney – Legally pets are considered tangible personal property and the person named in the durable power should be willing to care for the pet. If not, the owner should prepare a second document dealing with the caretaker and compensation for care of the pet.

Pet Care Trusts – Some states have adopted enforceable pet trusts enabling owners to transfer funds for long term care into a trust. The named trustee is responsible for seeing to the proper care of the pet. To ensure that the funds are spent properly, the grantor of the trust must also name a third party to oversee the actions of the trustee.

In states where pet trusts are not enforceable, the owner may wish to set up a traditional trust that names the trustee as a contingent beneficiary. The trustee is a fiduciary with fiduciary obligations to the pet. As long as the pet lives, the trustee receives distributions from the trust for the benefit of the pet.

A word of caution…this type of planning is not common and requires the assistance of a competent and experienced professional. However, given the wide range of pets, the extended life expectancies of some, and the love and devotion shared by owners, it is a part of estate planning that should not be overlooked.


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