The Deferred Annuity Alternative

The call for safe money in today’s world has never been greater. With the stock market at all-time highs and predictions of another crash, investors are looking for safe havens. Many are turning towards the indexed annuity; however, there may be an alternative which could provide more benefits in the long run.

Life insurance is often thought of as only providing death benefits to protect the family of the deceased by providing income, dollars to pay estate taxes, or legacy planning. However, with innovation and the newer products out today known as Indexed Universal Life, it is possible to emulate a tax-deferred annuity and end up potentially with far greater benefits.

A quick refresher is in order to discuss what happens when you over fund a life insurance policy too quickly, classified as a Modified Endowment Contract (MEC). It was Congress’s intention when it passed the Technical and Miscellaneous Reform Act of 1988 (TAMRA) to curtail the use of these policies as short term savings alternatives by imposing penalties upon the withdrawal of the cash values.  Ironically, a MEC is a very attractive form of life insurance and can be a fantastic alternative to the deferred annuity.

In comparison, withdrawals from deferred annuities are taxed in a manner known as LIFO which simply means last in, first out and, in addition, are subject to 10% penalty tax if taken prior to age 59-1/2. Recommendations by advisors are made to clients to purchase deferred annuities for those clients who have cash that they do not need to access for some period of time.

On the other hand, the tax consequences of a MEC will trigger the tax and possible penalty whenever cash values are accessed through loans, withdrawals, or the use of collateral for any loan. It is important to remember that the possible tax and penalties are levied only on the cash values, not the death benefits which are paid out tax-free to the beneficiaries. When cash values are borrowed from a MEC policy, tax is triggered on the gains. These too are taxed on a last in, first out basis up to the amount of any gains in the policy and any transactions wherein cash is withdrawn prior to age 59-1/2 there is also a 10% penalty.

As you can see, the tax consequences for removing cash from either the deferred annuity or the MEC policy are identical but there are several reasons for considering a MEC:

1.   Leveraging Cash Equivalents
Someone who is looking to have higher returns on their cash currently in Money Markets, CDs or Savings accounts and would like the tax-deferred growth on those values with an incredible feature of tax-free death benefits might want to explore the use of a MEC policy.

In structuring a survivorship policy, one can design it to purposefully remove or dramatically reduce surrender charges so that virtually 100% of the premium is reflected as cash value in the first year. Some policies may even provide guaranteed crediting rates of as high as 3%.
2.   Long Term Care Add-On

Today’s products allow us to create, in essence, a self-insured asset for long term care purposes. Utilizing a MEC policy with a long term care rider will serve two purposes for the client: tax-deferred growth and, in the event of a long term care need, the policy will provide benefits tax-free to the individual needing the long term care.

To sum up, this design allows the individual to reposition money into an annuity-like vehicle with the potential to participate in the S&P Index growth and at the same time have the peace of mind of knowing that they can access the policy values for either retirement or long term care benefits. Long term care benefits being accessed on a tax-free basis. Lastly, in the event of death, a very healthy tax-free death benefit.