Unused Annuity? How to Avoid Leaving Your Kids With the Taxes

Annuities are arguably the best way to create a stream of guaranteed retirement income that you cannot outlive. We help our clients use them in a comprehensive retirement plan that avoids the usual retirement risks.

It’s a popular option, too, with an estimated $2.52 trillion of retirement assets held in annuities just in the United States in 2021. 

But here’s where it gets complicated. 

Less than 5% of annuity contract holders end up annuitizing their contracts. That means over 95% of annuity holders live off the interest

It’s very sensible. Live off the interest while still having a large holding of cash available if an expensive emergency crops up. 

One way to make your annuity go farther is using the 10% one-time penalty-free distribution. This is especially advantageous if you’re part of the 95% of annuity holders living off of the interest. It lets you take advantage of the leverage-boosted tax-free income stream for your adult kids through a Kai-Zen policy.

If you aren’t familiar with the mechanics of a Kai-Zen policy or how it works, we recommend starting with this article: Life Insurance Estate Planning with No Taxes.

If you have any questions or want an illustration of what your situation may look like, give us a call at (858) 703-6178. Each policy is uniquely tailored to the needs and wishes of the family. 

Using Your Unused Annuity to Provide for Your Children

Jim (name changed for privacy) is 80-years-old. He has a $3 million annuity that he doesn’t plan on using. He likes living off the interest with the peace of mind that it’s there if a large medical expense comes up. 

Most annuities allow for a 10% penalty-free distribution. Jim’s did as well. 

In reviewing his estate planning, the subject of his daughter, Laura,  paying the income taxes on his annuity came up. She is the sole beneficiary and age 50. 

If Jim were to give his daughter $300,000 using his lifetime exclusion, what would be the potential return on investments for her? 

Here’s a quick overview of how it works:

Step 1: Use a Kai-Zen life insurance policy. This is a leveraged policy that adds 3:1 leverage to your contribution. In Jim’s case, it provides 300% more tax-free dollars to Jim’s daughter.

Step 2: Gift $300,000 or $60,000/year for five years to his daughter.

Step 3: She funds the $60,000/year for five years into a special type of life insurance policy that uses leverage. This policy will provide tax-free distributions and a chronic illness rider for Lauda. At her death, the policy will provide a tax-free death benefit for his grandkids.

potential returns from funding an Kai-Zen for your child with an unused annuity

Jim decided that the Kai-Zen would give Laura the biggest tax-free benefit. He also funded the five years of her premiums at once using the lifetime gift exclusion rather than the annual gift exclusion. 

In this case, he put the $300,000 in a trust that would pay the premium each year. He didn’t want to take chances with his health. 

If Laura passed away at age 90, this policy would leave his grandchildren with a tax-free inheritance of almost $1 million. 

What About Letting Them Inherit the Annuity?

Leaving an annuity as an inheritance for your children may not be the best plan. When the annuity holder dies, that might be the end of the annuity payments.

Another style of payment stipulates that the payments last for a specific number of years. In this case, if the annuity holder passes away, their beneficiary will receive the remaining payments until the end of the period. 

When the annuity holder dies, the person inheriting the annuity (usually the children) owes income tax on the growth of the annuity. That can be a surprisingly large tax bill on the difference between the principal paid in and the value at death, especially if it’s been held for a long time. 

Not thinking of the taxes, many of these inheritors also choose to get the lump sum amount. Then they discover the IRS wants those taxes immediately

In Jim’s case, setting up the Kai-Zen policy for his daughter ensures she can both pay the taxes on whatever she inherits and still use her Kai-Zen policy as tax-free retirement income.

Who Qualifies for This Sort of Leverage Strategy?

First, if you’re younger than 55, here’s what you need to show the underwriter:

  • Giftor must have at least $200,000 annual income (or $3+ million net worth)
  • Giftor must provide 2 years of income verification
  • Insured must also provide 2 years of income verification
  • Cover letter if the insured does not financially qualify on their own
  • Giftor must own a Kai-Zen policy for themselves
    • If giftor is uninsurable, the above is waived but details must be included in the cover letter

If you’re older than 55, here is the other set of qualifications.

  • Giftor must have at least $200,000 annual income (or $3+ million net worth)
  • Giftor must provide 2 years of income verification
  • Insured must also provide 2 years of income verification
  • Cover letter if the insured does not financially qualify on their own

How Does a Kai-Zen Policy Work?

The power of a Kei-Zen policy is letting leverage do all of the work. If you wanted to fund a regular IUL, you could. But without the extra 75% from the bank, you won’t have nearly the growth. 

Over ten years of funding, the bank will put up 75% of the premiums. You are only responsible for 50% of the premiums for the first five years. 

After ten years of funding, the cash value will grow on its own for another five years.  

After 15 years, your cash value has grown enough that the bank takes back its loan including interest. You get the cash value with 15 years of leveraged growth. Or, in this case, your adult child gets it. 

They can use it for whatever they wish after that 15-year mark. We’ve seen everything from using it for a downpayment on a home, college funding for their children, and even letting it grow until retirement age for a tax-free income stream. 

For an in-depth look at how Kai-Zen is funded, grows, and avoids taxes, read this article on building wealth with life insurance plus leverage

Next Steps

Every case is a little different. If you want to see some “what if” scenarios for your family, give us a call at (858) 703-6178. And if you’re under 55 years of age, you’ll need your own policy before the insurance company will issue any for your children. 

You can begin to estimate the benefits from your own policy by clicking the picture below.

Kaizen - click here to estimate your retirement income