How Life Insurance and Annuities Fit Into Estate Planning for High Net Worth Individuals and Families
Estate planning is an important process for all individuals, but it becomes even more critical for high net worth individuals and families. With larger, more complex estates comes greater potential for taxes, disputes among heirs, and other issues if proper planning is not in place. This is where life insurance and annuities can play a key role.
Overview of Estate Planning for High Net Worth
High net worth is generally defined as having over $5 million in net assets. At this level of wealth, estate taxes become a major concern. Under current federal law, estates valued over $12.06 million (for 2022, indexed for inflation) are subject to estate taxes as high as 40% for any assets above that threshold. Many states also impose their own estate and inheritance taxes.
In addition to tax minimization, other estate planning goals for the ultra wealthy include1:
- Asset protection to shield wealth from creditors and lawsuits
- Business succession planning for family enterprises
- Equal treatment of heirs
- Philanthropic planning and charitable giving
- Providing for grandchildren while minimizing generation-skipping transfer taxes
Achieving these objectives requires proactive planning with experienced legal counsel. Estate planning attorneys have numerous tools at their disposal, from various types of trusts to limited liability entities. But two products that should not be overlooked are life insurance and annuities.
Using Life Insurance in Estate Planning
Life insurance can serve many purposes in an estate plan, providing liquidity, wealth replacement, and tax optimization. With its tax-free death benefit, life insurance is a highly efficient way to transfer wealth. Strategies may include2:
- Paying Estate Taxes
For ultra high net worth estates, taxes can claim 40% or more of the overall value, potentially forcing heirs to liquidate assets just to pay the tax bill. Life insurance provides an income tax-free death benefit that can cover this liability. Special trusts may be used to keep the death benefit out of the taxable estate.
- Equalizing Estates
Often one heir, such as the oldest son, may inherit a family business or large block of stock. Life insurance on that individual can provide a death benefit to equalize inheritances for other heirs.
- Funding Buy-Sell Agreements
Buy-sell agreements govern what happens when a business owner dies. Life insurance can provide liquidity for surviving owners to purchase the deceased's share from heirs.
- Replacing Wealth and Income
Life insurance can replace the future earnings and wealth-building capacity lost when a high income earner dies prematurely. This ensures financial security for surviving dependents.
- Funding Retirement Plans
At death, balances in retirement accounts are income taxable. Life insurance can create a tax-free pool of wealth for heirs while leaving retirement assets to fund a spouse's future retirement needs.
- Charitable Bequests
Those with philanthropic intentions can use life insurance to replace wealth designated for charity, allowing other assets to pass tax-free to heirs.
Choosing the Right Life Insurance
Several factors determine the appropriate life insurance solution for estate planning, including age, health, and total coverage needed. Term and permanent life insurance both play important roles3.
- Term Life Insurance
Term life provides pure death benefit protection for a set period of time, such as 10 to 30 years. It is an affordable way to meet temporary needs like covering an outstanding mortgage, funding children's education, or providing income for a surviving spouse until retirement.
- Permanent Life Insurance
Permanent life insurance covers a policyholder for life, as long as premiums are paid. It also features a cash value account funded by policy premiums which grows tax-deferred over time and may be accessed through policy loans and withdrawals. This gives permanent life insurance the ability to meet multiple estate planning objectives.
Common permanent life policy types include:
- Whole Life – Offers lifelong coverage with guaranteed cash value growth and often a guaranteed level premium. It provides strong asset protection features as well.
- Variable Life – Provides exposure to a variety of stock and bond investments within the policy's separate account. Cash value and death benefit fluctuate based on account performance.
- Universal Life – Features flexible premium payments and provides policyholders greater control in allocating premiums between death benefit and cash value growth.
Permanent policies, such as second-to-die policies covering both spouses, can be structured to pay large death benefits that can be used to settle estate taxes and equalize inheritances. Taking loans and withdrawals from cash value during life are also tax-advantaged ways to access death benefit proceeds early if needed.
Using Annuities in Estate Planning
Annuities offer several unique benefits that make them useful estate planning vehicles for high net worth individuals4:
Guaranteed Income
Income annuities provide guaranteed income for life, helping hedge longevity risk. Payouts can cover lifetime expenses, preserving other assets to pass on to heirs.
Probate Avoidance
Like life insurance, designating annuity beneficiaries avoids the asset going through probate. This provides faster access to funds for heirs and keeps the asset out of the taxable estate.
Tax Deferral
Annuities grow tax-deferred, meaning more wealth can be accumulated leading up to retirement and passed on. Taxes are only owed on gains when distributions are taken.
Asset Protection
State laws protect annuities from creditors in bankruptcy proceedings. Qualified longevity annuity contracts (QLACs) receive additional federal protections limiting creditor access.
Tax-Efficient Wealth Transfer
Unique annuity features like guaranteed withdrawal benefits can provide heirs enhanced wealth transfer opportunities not found with traditional investment accounts.
Choosing the Right Annuity
There are many different types of annuities, offering unique options to meet estate planning objectives5:
Immediate Annuities
These provide guaranteed payouts that begin within 12 months of purchase. They can create reliable lifetime income streams for the annuity owner while preserving other assets.
Deferred Annuities
These allow savings to grow tax-deferred until a later date when payouts begin. Funds accumulating in a deferred annuity until death will pass income tax-free to heirs.
- Fixed Annuities
Fixed annuities credit interest at a guaranteed minimum rate, allowing wealth to grow safely. Any account gains pass to heirs tax-deferred.
- Fixed Indexed Annuities
These annuities earn interest based on stock market index returns while protecting against losses in down years. Upside potential continues even after the owner's death.
- Variable Annuities
These invest account value in mutual fund-like subaccounts for unlimited growth potential. Beneficiaries can elect to receive either income or lump sums from any remaining account value.
- Qualified Longevity Annuity Contracts (QLACs)
QLACs are special deferred income annuities that begin payouts after age 85. They provide tax-advantaged lifetime income while allowing more savings now to pass to heirs estate tax-free.
With many options available, structuring the right annuity for estate planning purposes requires an understanding of each individual's financial priorities for retirement, legacy goals, and risk tolerance.
Combining Life Insurance and Annuities
Using life insurance and annuities together can create synergies and flexibility in estate planning not offered by either solution individually6. A common scenario is using an annuity to create reliable lifetime income, thereby allowing other assets to remain invested more aggressively for growth. The risk created by maximizing investment returns can then be offset with life insurance.
Life insurance death proceeds minimizes the negative consequences should overly aggressive investments decline substantially. Meanwhile, the policy's cash value provides living benefits that can be tapped if ever needed.
Advanced strategies can also incorporate various annuity and life insurance policies into irrevocable life insurance trusts (ILITs) or other trust structures to create layers of tax advantages. Trust-owned annuities also avoid probate and protect assets from creditors.
A financial advisor who specializes in estate planning can help high net worth individuals integrate annuities and life insurance together, and with other wealth transfer vehicles, to develop optimal solutions.
Conclusion
Estate planning is a complex, yet essential process for protecting and preserving wealth to pass onto future generations. Taxes, asset protection, business succession planning, and wealth replacement must all be addressed. Annuities and life insurance should be key components of every high net worth estate plan.
Used independently or together in coordinated strategies, annuities and life insurance may provide tax efficiencies, guaranteed income, creditor protections, probate avoidance, and wealth transfer opportunities that work powerfully in concert with trusts and other estate planning tools for the ultra wealthy.
Variable annuities are long-term, tax-deferred investment vehicles designed for retirement purposes and contain both an investment and insurance component. They are sold only by prospectus. Guarantees are based on the claims-paying ability of the issuer and do not apply to a variable annuity's separate account or its underlying investments. The investment returns and principal value of the available subaccount portfolios will fluctuate so that the value of an investor's unit, when redeemed, may be worth more or less than their original value. Withdrawals made prior to age 59½ may be subject to a 10% additional tax. Surrender charges may apply. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal.
