Moment on Money

Dissecting a Capital Transfer Plan

Every regulatory authority, designation grantor, and of course the State of Iowa have different continuing education requirements which I must comply with. Long ago, one of my early role models told me "if you are going to be a real professional in this field, you will constantly need to be taking continuing education courses. Forget about the minimums. Just go out there and learn." I have followed his wise advice ever since and absorb as much CE as I can fit into my schedule.

Recently I was at a CE program titled capital transfer planning. The presenter examined various methods of conservatively passing money from one generation to the next (ignoring the impact of estate taxes – that is another subject entirely). As an example, the presenter assumed a 65 year old male client with $100,000 of "idle assets" and an assumed 25% marginal tax rate. First, let's define an "idle asset" as money which is not planned for consumption during the client's lifetime. Many people have assets which they never intend to spend and leave to their heirs.

The course examined three options:

1. A CD @ 2% (interest from CD's is generally taxable)
2. A Fixed Annuity @ 4% (annuities offer tax deferral on interest)
3. A modified endowment contract (MEC). Modified endowments are life insurance policies which are heavily funded early on. Since this comparison assumes a single premium of $100,000 and no additional premiums, this life insurance policy would definitely be a modified endowment. Having a modified endowment has no impact on the death benefit but does have implications on withdrawing any cash value while the insured is still alive.

We were provided a worksheet which shows what the heirs would receive, net after tax, from each option in 5, 10, 15, and 20 years. For simplicity, the presenter called this amount the death benefit and it is labeled DB on the chart. The Yield is the average annualized return. For example, since the CD provides the heirs with $110,408 (after tax in 5 years) the chart indicates that would have been equivalent to earning 2.08% each year on the money. The formula for this calculation is to take the average gain per year divided by the initial deposit; (($110,408 - $100,000)/5)/$100,000.

DB = Death Benefit AY = Annualized Yield	Taxable CD @ 2.0%	Tax Deferred Fixed Annuity @ 4%	Modified Endowment Life Insurance Policy
After 5 Years	DB: $110,408 AY: 2.08%	DB: $112,999 AY: 2.6%	DB: $396,244 AY: 59.2%
After 10 Years	DB: $121,899 AY: 2.19%	DB: $128,814 AY: 2.88%	DB: $396,244 AY: 29.6%
After 15 Years	DB: $134,587 AY: 2.3%	DB: $148,056 AY: 3.2%	DB: $396,244 AY: 19.74%
After 20 Years	DB: $148,595 AY: 2.43%	DB: $171,467 AY: 3.57%	DB: $396,244 AY: 14.81%

The conclusion is obvious – even though the yields of the CD and the annuity are rising and the yield of the MEC is falling, this person cannot live long enough for the modified endowment to be surpassed by either the CD or the fixed annuity. The case for a MEC is further supported because the yield on the MEC is known in advance while the interest rates on the CD and fixed annuity will fluctuate with economic conditions. But does that mean a modified endowment life insurance policy is the best option for all idle assets?

The presenter of the CE program obviously thinks so, but I think there are two key factors which must be considered. First, is the person insurable? If the person has health issues the effectiveness of life insurance may be reduced (or not even available). Probably more important is determining the certainty that this asset will never be touched.

Aldous Huxley said "Hell isn't merely paved with good intentions; it's walled and roofed with them. Yes, and furnished too." While a capital transfer plan employing a MEC can be attractive, one has to consider the certainty that they will never need liquidity from those funds again. With surrender charges applicable to most life insurance contracts, chances are the CD or even the fixed annuity would win if we compared accessing the cash values across the same timeframe. With this in mind, I would only support this type of capital transfer plan if there were other sources of liquidity and the client had adequate protection in place for unforeseen financial stresses such as the need for long term care.

A Reader Asks #17: Taxing Annuity Changes

This question came recently via emai:

Dear Mr. Dinkin,

I found your website after searching the web for an answer to a 1099-R question. I thought your website was helpful, but I'm not sure how to decipher the 1099-R I received.

My situation is this. My husband and I took out annuities through [company name removed] for our children; one in 1987 and the other in 1988. We took these annuities out for each of them as a 'college savings account'. Each of the annuities had both my husband's name and the individual child's name on them. My husband was listed as the owner and our child was listed as the annuitant.

Both of the children turned 21, we of course still had the annuities. When they turned 21 the annuities were turned over to them, without our request. The company said this happened because they turned the 'age of majority.' My husband and I gladly relinquished this money to them, but we ended up receiving a 1099-R form for them and had to claim it on our income taxes due to a code of 1 in box 7 on the 1099-R.

I learned about these codes by reading your article Unlocking Box 7. I simply don't understand why we had to pay taxes on these contractual annuities when there was no cash distribution.

Is it possible for you to help me shed some light on this puzzle?

I can shed some light on this, but unfortunately I may raise more questions than I answer. From my perspective as a financial planner, there are several key issues to consider.

Account Ownership

As presented, something is not quite right in regards to who owns these annuities. Since ownership of the annuities automatically transferred to the children when they reached the age of majority, I do not think the husband ever really owned the annuities. It sounds like the husband was the custodian of the annuities and his role was to act in the best interests of the children until they reached the age of majority and assume the responsibility for themselves. If I am correct that the annuities were set up under UGMA/UTMA, then there was no change of ownership when the children reached the age of majority. On the other hand, if the husband actually was the owner of the annuities then I cannot explain why his property transferred to the children without his consent.

The account ownership issue is quite significant. Not only does that directly affect potential taxes on a change of ownership (see below), but there is also the issue of a potential 10% penalty for premature distribution from an annuity. If the child is the true owner of the annuity, then it makes a poor choice for college funding. While the annuity enjoys tax deferral during accumulation, there is a 10% penalty on amounts withdrawn prior to the owners age 59 ½. My guess is that most parents want their children to receive their education before they are middle aged.

Income Tax

Again, annuities are tax deferred vehicles so no income taxes are due on gains within the contract until they are "recognized". Generally, this means that money is withdrawn from the policy but recognition can also occur when ownership of the annuity is transferred. When the annuity is transferred, the previous owner recognizes (and pays ordinary income tax) on any gain in the annuity. The new owner's cost basis is the value at the time of the ownership change.

I think this is why this person received a 1099. Since there was a change in ownership, the amount in the account at the time of ownership change is reported to the IRS. If that balance is more than the sum of the contributions, the previous owner has an income tax liability. In the email, the person indicated that Box 7 of the 1099 was coded with a 1 which indicates that the owner is younger than age 59 1/2. In addition to income tax the 10% penalty may also apply.

Gift Taxes

Don't overlook this potential problem too. If the annuities are worth more than $13,000 ($12,000 if we are referring to 2008), then you need to consider gift tax consequences too. Since the person in this example is married, they can elect to split the gifts between the spouses which effectively doubles the gift tax threshold.

The account ownership issue continues to puzzle me. Knowing that your children automatically became the account owners, I have to question if your husband was ever the actual owner of the contracts. It seems to me that your husband was acting as the custodian on behalf of your children but then I cannot explain a tax issue on transfer. If your husband truly was the account owner, then I cannot explain why ownership transferred without his consent.

I would definitely bring this to the attention of my tax advisor before filing a tax return.

This is not intended as tax or other legal advice. For advice on your specific situation you should contact your attorney.

Is there a financial topic you have a question about? Or is there something you have always wanted to know but were afraid to ask? This is your opportunity! Send me an email and ask your question. I will publish the answer here at the blog and promise to keep your identity confidential. No cost. No obligation. No strings attached.

mail by chona kasinger

You Just Never Know

The call came late in the day as I was getting ready to leave the office.

"Hello Art" the caller started, "My name is Mr. X and you are my daughter's financial planner. I think you know she has been ill lately. I am calling to let you know that her funeral was late last week. I am her executor. Do you have any idea what assets she owned and where they are?" A call like that does not end the day well.

I met his daughter just five years ago at a class I present occasionally for the Urbandale Parks & Rec department. She was 40 years old when I met her. Divorced with full custody of a 15 year old son and a steady job with a State agency, her goals were related to retirement planning and education for her son. Over the course of several meetings we established her retirement needs and goals, allocated resources to meet those goals, and started saving for her son's education. As part of the analysis we reviewed her insurance coverage. The state provided excellent health and disability insurance but only a minimal amount of life insurance. I encouraged her to consider purchasing life insurance to supplement the coverage the state provided. Thankfully she not only listened, but she followed my advice.

It is hard for me to accept that within 5 years, this active healthy woman went from easily qualifying for life insurance… to dead.

In her situation she saw it coming. Knowing she was quite ill, we met 18 months ago to review her beneficiaries. I recommended she meet with an estate planning attorney to review her will. These are the action items you can accomplish if your doctor delivers news of the worst kind. At that point, it would have been impossible to purchase additional life insurance.

In the last year I know of a man in his late 30's who had a mild heart attack; a woman in her mid 40's who is currently in radiation and chemotherapy for cancer; and a man in his early 50's who was hospitalized twice for pancreatitis before his gallbladder was removed last month. Fortunately for all three of these individuals, their prognosis is good but their ability to purchase additional insurance has been seriously curtailed. Two years ago, none of them knew this would happen.

I share this so that we can all learn from the moral of the story. It is better to plan for the worst and hope for the best, than it is to plan for the best and worry about the worst.

For Mr. X and his family, there is nothing I can do to relieve their loss nor was there anything I could have done to prevent this. I can take some solace in the knowledge that I did the best I could for his daughter. I do have a comprehensive list of her assets, I know what she owned and where to find it, I am working with him and the attorney to make sure her final wishes are carried out, and she passed knowing that her planning provided for her son and his education. Given the situation, I don't know how this could have ended any better.

Want to Trade?

Suppose you were given the opportunity to "sell" your career. How much money would you have to receive now, with the condition that you could never be paid for work again, to walk away from your paycheck?

In one sense, it would be like an early retirement. You would have a sum of money which would need to support you and your family for the rest of your lives and your time would be free to do with as you please. Maybe you would live a life of leisure? Be a volunteer? Make the world a better place for mankind?

What factors would you use in your calculation? Probably your age, income, marital status, your children's age and future education needs, and your current assets and debts.

Give it some thought. Would you trade me your career for $100,000, $1,000,000, or even $10,000,000?

Now I need to ask, how much life insurance do you own? Is it less than the trade value of your career? Why?

Recently I was working with a young doctor who has a family. His wife did not work outside of the home. He owns about $1,000,000 of life insurance and my calculations showed he needed closer to $3,000,000 but I could tell he was uncomfortable with that amount. So I asked him "Would you trade me your career, with the understanding that you could never receive a paycheck again, for $1,000,000?"

He quickly realized why he was underinsured.

Walking Away by quinn.anya

Inforce Illustrations

Yesterday I offered a self evaluation on how well you know your own life insurance. Today I promised to tell you where you can find the answers.

It doesn't matter what kind of life insurance you own. Periodically you need to ask your agent (or the company) to provide you with an inforce illustration. These are just like the ledgers an agent may show you before you purchase a policy but now, since the policy is in force, it starts with the policy's current values.

All life insurance illustrations show a "current" scenario and a "guaranteed" scenario.

The current inforce scenario starts with the current policy values and assumes future premium payments will be made as planned. Interest rates, insurance charges and other fees/costs will be projected to remain the same as they are now.

The guaranteed inforce scenario starts with the current policy values and also assumes future premium payments will be made as planned, but the interest rate is lowered to the contractual minimum while the insurance charges, fees, and costs are raised to the contractual maximums. In other words, the guaranteed scenario is the worst case situation.

If the policy pays dividends, the current scenario assumes the dividend scale will remain unchanged but since dividends are not guaranteed, the guaranteed scenario assumes no more dividends will ever be paid.

When reviewing your inforce illustration, pay extra attention to the death benefit. If at any time the death benefit reaches 0, that means the policy has lapsed. If the death benefit is gone, I would bet the cash value is gone too. That leaves you with no residual value and no future benefit.

Also look over the premiums. Is there a change in premium? Has the assumption been made that you will increase (or decrease) your premium in the future?

Always remember that illustrations are projections. Unless the insurance company is already at minimum interest and maximum charges, the policy has potential to perform better than the guaranteed scenario but current projections could end up being better or worse than policy will actually perform. Personally, since I do not believe in life insurance as an investment, I tend to focus on the guarantees. Anything that happens better than that can never hurt.

Inforce illustrations also offer the ability to ask "what if?". For example, ask the agent (or company) to re-run the inforce illustration if you stopped paying premiums when you now, or when you plan to retire. You could even ask them to calculate the premium required for you to stop paying the premium in a particular year but still have a guaranteed death benefit.

Reviewing the inforce illustration every five years or so will keep you aware of any issues with your life insurance while you have enough time to prevent the problem.

The Prudential by ambimb

Self Evaluation: How Well Do You Know Your Own Life Insurance?

A while ago Drew McLellan made the suggestion that I give some self-evaluation quizzes and today I am going to give it a shot. I would love to hear your feedback. Let me know if you like worksheets like this or if you do not.

How Well Do You Know Your Own Life Insurance?

1. How much do you pay for your policy?
2. Can the rate ever change? If so, when?
3. Does your policy build cash value? If so, how much cash value is there? Is the policy subject to any surrender charges?
4. If you keep paying your premium the same as you are now, how much coverage would you have when you are 65? 80? 100?
5. Is there ever a time when your death benefit will decrease?
6. If you stopped paying your premiums today, would you still have any coverage? If so, how much and for how long?
7. Who are the beneficiaries?
8. What would happen if your beneficiary dies before you (or with you)?

There is no scoring system. If you can answer these 8 questions (even most of them) then you know more about your life insurance than most people do. If you do not know the answers, be sure to read my next post on where to find them.

The Prudential by ambimb

Life Insurance Risk Classes

I often hear the ads on the radio which tout low term life insurance rates. A forty year old man can get ump-teen bazillion dollars of insurance for just 62 cents a year or something fantastic like that. Are these deals bogus? Of course not. But these ads fail to disclose just how rarely someone can actual qualify for those rates. These seemingly too good to be true offers are legitimate but assume that applicant will qualify for those best rates even though only a small percentage actually do. The public has little understanding of how life insurance companies classify their insured's so here is a basic primer.

Let's start with healthy people. Most life insurance companies have at least three and sometimes four different ratings for people who are healthy. In a three tiered system you have:

• Super Preferred
• Preferred
• Standard

A four tiered system would have a Standard Better rate between Standard and Preferred.

The vast majority of healthy people would be underwritten as Standard or Standard Better risks. To get a Preferred or a Super Preferred rating you have to be very close to ideal in your weight, blood tests, medical history, avoid hazardous activities, have a good family history, and be on few (if any) medications. For example, I am a pilot so even if every thing else was ideal I would never qualify for Super Preferred. In fact, most companies would never consider me at anything better than a Standard rate.

Many companies and insurance agents feel compelled to quote Super Preferred rates so they appear to be the least expensive. I shop life insurance at Standard of Standard Better rates which are much more realistic. When you apply for insurance you are applying for coverage, not a rate. The underwriter will assign the best rate you qualify for regardless of the rate you were quoted. By shopping at rates which are more realistic, a Preferred or Super Preferred rating is always a welcomed surprise.

To keep the issue confusing, there is no uniformity in the labels the companies put on their ratings. For example, one company I know of uses a three tired system of Premiere, Preferred, and Standard. Another calls the same three rates Select Plus, Select, and Ultra Standard. No wonder it is confusing.

Tobacco Use is also another area for confusion. Most companies offer the same basic ratings in a tobacco and non-tobacco version (yes, it is possible to be a Super Preferred Tobacco user but very unlikely). Even the definition of who is a tobacco user and who is not will vary from company to company. In it's strictest definition, anyone who has used any form of tobacco at all within the last year would be a tobacco user. Other companies will grant cigar smokers, tobacco chewers, and/or occasional cigarette smokers non-tobacco ratings.

There are some people who do not qualify for Standard ratings and those are referred to as Substandard Risks. Again, every company takes a different position when underwriting health issues. For some, diet controlled diabetes is not an issue when for others it is considered the same as being heavily insulin dependent. Discrepancies between companies are common with everyday health issues like high blood pressure, cholesterol medications, history of cancer, or heart issues. Even insurance agents find it difficult to keep up with the marketplace as underwriting standards are frequently changing.

Do not be tempted by rarely fulfilled promises of low cost life insurance. Meet with a professional with whom you can discuss your situation and health history. Then you can find the lowest cost coverage for YOU.

Realtone 6 Transistor Radio, 1960's by Roadsidepictures

What to do with old Whole Life policies

Like everything else the life insurance industry has changed and evolved. There was a time when I would have praised whole life policies as the best available permanent insurance protection. With the innovation in the industry, today I sing a different tune.

A whole life policy offers three guarantees; the premium, the death benefit; and the cash value. But why should a life insurance policy even offer cash values? Insurance is not the most efficient investment platform. Today there are universal life insurance contracts with a no lapse guarantee which can guarantee the death benefit and premium, but offer no guarantees about the cash value. If I have a life insurance policy that has a level premium and a level death benefit but offers no cash value, it for all intents and purposes becomes a term insurance policy for the rest of my life. As long as the death benefit is there when my family needs it, I don't need cash value. After all, there are better investments than insurance. The best aspect of these "term for life" contracts is that the premiums can be significantly cheaper than whole life.

Here is an example. I have one client who had purchased three separate whole life polices over the years. The combined death benefit was about $109,000 and he was paying about $75 a month for the coverage. The three policies had a combined cash accumulation of over $38,000. He needs and wants the death benefit but the cash values are meaningless to him. He understands that if he gains access to the cash values, the death benefits will reduce. We explored options and discovered that he could transfer the cash values from the whole life policies into a new no lapse guarantee universal life contract. His new death benefit would be over $160,000 and would be guaranteed to require no additional premium. More coverage and he saves $75 a month. I think his exact words were "that is a no brainer".

There are a few things to consider:

• Access to the cash value is reduced (and may be completely lost)
• The guarantees are those of the insurance company. Like any promise, they are only as good as the company.
• Purchasing a new life insurance policy is subject to both medical and financial underwriting.

On the Radar: Tax Effect of Return of Premium Life Insurance

Sorry the blog has been quiet for a couple days. I went to a conference out of state and it interfered with my writing schedule. That combined with the delay I need to get my blog material reviewed by compliance results in a few missed days. Thanks for being patient. The good news is the conference was good and I will be writing about some of the topics in the near future.

Last October I wrote about Return of Premium Term Life Insurance. I have been considering return of premium (ROP) as an option for several clients and the results are very interesting. In some cases, ROP makes a lot of sense and in others it doesn't. It all depends on the rate of return you would need to earn if you purchased a regular term and invested the difference in a side fund.

Calculating the raw return of the return of premium policy is straightforward. Here are the variables which can be plugged into any financial calculator:

• N = number of years
• PV = 0
• PMT = the difference between the annual cost of a straight term and the ROP term
• FV = annual cost of the ROP term multiplied by the number of years
• For greatest accuracy all payments should occur at the BEGINNING of the period.
• Calculate for INT/yr.

Recently I have been giving a lot of thought to the tax effect of this analysis. If you purchase ROP term, the money you receive at the end of the term is not taxable since there is no gain … it is a return of the premiums you paid. However, if you purchase the regular term and invest in a side fund, the gains in the side fund will be taxable. In order to calculate the tax effective rate of return of the ROP policy, you need to add the tax liability to the future value so you have the same net result after taxes.

I've made it easy for you. Here is an excel spreadsheet (Download rop_analysis.xls) to do the math for you. All you need to do is provide the cost of the regular term, the cost of the ROP term, the term period, and a tax rate. The spread sheet will calculate both the raw return and the tax effective return of the ROP policy.

Keep in mind that the raw return is guaranteed by the issuing insurance company. The effective return is based on that guaranteed return and the tax rate you provide. If the tax effective return is attractive, purchasing ROP makes a lot of sense considering the very low risk.

Radar by BenFrantzDale

Financial Evolution

I was talking with a colleague the other day. We were discussing recent case work when a fairly new associate came in to the room and wanted our assistance analyzing a case he was working on. His prospective client was considering purchasing a variable universal life insurance policy to fund his children's college education. For the record, this was not our associate's recommendation. Someone else the client had been talking to made that proposal.

The three of us discussed concepts I have openly written about here. Things like saving for education should not detract from retirement funding, life insurance needs can all be defined into "If I die" and "When I die" categories, "If I die" needs are best served by term insurance, "When I die" needs require permanent insurance, but in most cases life insurance makes a lousy investment.

In the course of our discussion we came to the conclusion that life insurance could accomplish the client's goals, but that new tools have evolved which are a lot more attractive. For example, term insurance rates have declined so dramatically that we can purchase the death benefit separately. This leaves the remainder of the budget to accumulate without the drag of insurance costs.

When I first started my career (1989) we still carried rate books, computed premiums on a pad of paper and desktop computers were just being introduced into the business world. The fax machine was a revolutionary method of instant document transmission, but was difficult to deal with as the thermal paper would fade over time and had a tendency to curl up back into a roll. I was proud the day I had a car phone installed so I no longer had to carry bags of coins and search for a pay phone to make calls away from my desk.

Today we send instant e-mails on our laptops, can do complex analysis very quickly, and need to shut off our cell phones so no one calls when we need some quiet time. So many organizations are going "paperless".

Tomorrow someone may look at today's solutions and consider them as inefficient as using whole life insurance for college funding. The tools have changed.

Financial product development is happening with amazing speed. I doubt it will ever slow down.

11/02/2007 (Day 73) – Evolution by Kaptain Kobold