Table of Contents introduction & vocabulary 2

Annuities and Life Insurance

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  Code § 72(a). Annuities; certain proceeds of endowment and life insurance contracts—General rule for annuities.
  
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  Code § 72(b). Annuities; certain proceeds of endowment and life insurance contracts—Exclusion rules.
  
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  Code § 72(c). Annuities; certain proceeds of endowment and life insurance contracts—Definitions.
  
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  Code § 72(e)(1). Annuities; certain proceeds of endowment and life insurance contracts—Amounts not received as annuities—Application of subsection.
  
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  Code § 72(e)(2). Annuities; certain proceeds of endowment and life insurance contracts—Amounts not received as annuities—General rule.
  
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  Code § 72(e)(3). Annuities; certain proceeds of endowment and life insurance contracts—Amounts not received as annuities—Allocation of amounts to income and investment.
  
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  Code § 72(q). Annuities; certain proceeds of endowment and life insurance contracts—10-percent penalty for premature distributions from annuity contracts.
  
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  Code § 101. Certain death benefits.
  

1. 
   All up front: No income until year 3 ($32.70)
   
2. 
   Fixed Ratio: $267.30/300 = 89.1%  each year income = $10.90 (x 3 = $32.70)
   
3. 
   Bank account: equivalent interest paid each year
   

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  Annuities
  
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    Can be used to shelter earnings from taxes
    
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    Traditionally: a contract to pay a lump sum up front and receive a set payment each year for a specific amount of time
    
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    Subsidizing savings relative to a bank account
    
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    Annuities allow us to protect against:
    
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      Mortality risk (that we outlive our savings)
      
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      Does this allow us to tax the ideal? Does it measure ability to pay?
      
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      Inefficient? Creates incentives to invest for tax reasons and NOT because we value their insurance values
      
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  Life Insurance
  
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    Exempts all earnings on savings from tax
    
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    Most has savings AND term insurance (protects beneficiaries against premature death)
    
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      Pure term—insure against death in the following year
      
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      Whole life—pay much more now and no matter when you die you get the same payout—basically pay a series of pure term payments upfront
      
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    Liquidity of cash makes it more valuable
    
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    POLICY CONSIDERATIONS
    
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      Estate preparation--
      

1. 
   Oliver is retired and contemplating two investments. One is the purchase of an annuity for $7,000. It will pay him (or, in the event of his death, his heirs) $1,000 per year for 10 years. Alternatively, he could deposit $7,000 in a bank account paying 7% interest. On a pre-tax basis, this would permit him to withdraw $1,000 a year for 10 years after which point his balance in the account will be zero.
   
   1. 
      In a world without taxes, what would you advise?
      

2. 
   In light of the tax consequences, what would you advise?
   

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  Exclusion ratio = initial investment/total nominal payments = 7,000/10,000
  
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   (.7*nominal payment) is excluded as recovery of basis under § 72
  
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  annuity takes advantage of deferral value of TVM
  
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  treating the annuity like a bank account would be like taxing the imputed interest on an annuity
  

3. 
   Which investment is taxed more in line with the Haig-Simons definition of income?
   

2. 
   Paula is also late in life and contemplating two investment alternatives. She does not need any income herself and is only concerned with maximizing the amount of money that she can pass on to her heirs. The first is the purchase of a life annuity for $7,000. It will pay her $1,000 per year for the remainder of her life, which the annuity provider estimates to be 10 years. She will deposit these payments in a bank account paying 7% interest and bequeath the balance to her heirs. The second is the purchase of universal life insurance for a one-time payment of $7,000. Upon her death, the life insurance policy will pay her heirs $13,864, which is the present value of $7,000 in 10 years assuming an interest rate of 7%.
   

1. 
   In general terms, what are the tax consequences of each investment?
   

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  Annuity: she’s taxed with exclusion ratio (70%)  include $300 income/yr for the first 10 years
  
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    If she dies after 5 years
    
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      5 years basis recovery = 5*$700 = $3,500  can deduct unrecovered basis (= $3,500) on her last tax return § 72(b)(3)-(4)
      
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    If she dies sometime after 10 years
    
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      She’ll have recovered all of her basis  all of her $1,000 annual payments after first 10 are taxable income § 72(b)(2)
      
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  Life Insurance
  
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    § 101(a) if you get the payment by reason of death she can exclude it entirely (doesn’t matter if Paula or her heirs are direct beneficiary)
    
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    § 102—this would be a bequest and not taxable
    
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    Life insurance: entire gain on life insurance is tax exempt—including savings element (not specifically defined anywhere in Code)
    

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  Annuity—tax is deferred, taxed only on gain of savings element and mortality gain/loss if the life expectancy estimate is off
  
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    What is a mortality gain?
    
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      Only comes into play if the insured dies off schedule
      
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      LIFE INSURANCE: If you die BEFORE you’re supposed to you get a mortality gain (which isn’t taxable because it’s L.I.)
      
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      ANNUITY: If you die AFTER you’re supposed to you get a mortality gain because you’re getting more payments than they thought you should (more than you technically paid for)
      
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    What if you might cash-out the policy?  MODIFIED ENDOWMENT CONTRACT
    
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      Tax treatment would become similar—would lose the tax-benefits of life insurance § 72(e)
      
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      § 72(q)—if you cash-out prior to 59½ you pay a 10% penalty (unless you have a terminal disease or disability—special exceptions)
      

2. 
   If Paula expects to live 10 years, what would you advise?
   

3. 
   If she expects to live 5 years?
   

4. 
   If she expects to live 20 years?