If you have a client with a deferred annuity and no intention of using it for income, Keith Singer, a certified financial planner and attorney in Boca Raton, Fla., has a strategy for you.
"Convert the annuity to a modified endowment contract and your client will leave his or her spouse and kids way more money," he says. "It's a no-brainer."
A modified endowment contract (MEC) is a sort of cash-value life insurance policy with tax advantages, and with the ability to be funded with more money than normally allowed by federal laws.
Created in 1988 when Congress passed the Technical and Miscellaneous Revenue Act, it comes with a death benefit that passes to beneficiaries tax-free. "It's a huge windfall for the family," says Singer.
With a deferred annuity, of course, the value grows on a tax-deferred basis for as long as the policyholder maintains it. Gains in the deferred annuity will be subject to ordinary income tax when they are cashed in by heirs. So the longer the annuity is held, the bigger the liability. "The longer you live, the more the value will grow," notes Singer. "But for your heirs, that means the more taxes are going to be due on the death benefit."
To be sure, the conversion to an MEC is not a tax-free event, as with a Section 1035 exchange, which converts one annuity or life insurance policy for another. "It's more like converting a traditional IRA to a Roth IRA," he says. "But it's still beneficial to do it. "
Moreover, Singer has a strategy for making the conversion as painless as possible. Taxes on the MEC's interest can be paid with tax-advantaged borrowing. "Take a loan against the MEC from the insurance company, and effectively use that to pay the taxes," he says. "If you take the loan before the first anniversary of the MEC—before there's any interest credited—there won't be any additional tax consequences. It's actually a better transaction for the client than just paying the taxes out of pocket."
There are, however, a couple of provisos. First, these conversions are probably not for clients who intend to use their deferred annuity to generate retirement income. Second, because of the death benefit, the client has to qualify as sufficiently healthy for the MEC. "There is medical underwriting," says Singer.
But there may be a solution for that, too. If the client is not considered insurable, but the client's spouse is, the client can cash out of the annuity and convert it to an MEC for the spouse. "It does not have to be the same annuitant to use this strategy," he says. "It's very simple to do."
Singer's website about MECs, www.modifiedendowmentcontract.com, will launch next week.