Putting Estate Planning Strategies To The Test
“No shot that is right.”
This thought swirled in my mind as I was sitting at a conference this past week.
The presenter was discussing a “tax-efficient wealth transfer” tool touting the benefits of using a non-qualified annuity which would allow for the beneficiaries, upon the owner’s death, to stretch the required distributions over their lifetime.
Why is this beneficial?
The SECURE Act. 2.0 eliminated the ability for beneficiaries to stretch their qualified account distributions based on their life expectancy & required them to pull out the full account value within 10 years (assuming the beneficiary is an non-eligible designated beneficiary - more on that HERE) - but this doesn’t apply to non-qualified annuities (they keep the stretch rules).
Sounds great - you preserve the stretch ability, but does that make it more beneficial than a traditional brokerage account?
That is what caused me to raise an eyebrow.
It wasn’t that this was an inherently bad idea, rather, there were no circumstances or conditions being placed around why the strategy makes sense for a specific scenario.
And being honest… It was just being talked about like we discovered gold for the first time (which further fueled my curiosity).
No strategy is great without context.
Sitting in the audience my raised brow turned into impatience as I wasn’t the full picture being displayed. As I got the opportunity to ask a question, I did:
“Provided non-qualified annuities avoid the step up in basis & offer ordinary income rates on distributions which come out as gains first, how does that compare to a non-qualified brokerage account that gets a step up in basis & offers distributions at capital gains rates?”
The answer?
Not only was the question not answered - everyone else seemed to have glanced over this lack of answer & continued to ask more questions about the nature of the product over the nature of the circumstances that make the product make sense.
In light of this, I wanted to run this ground ball out myself.
Is there validity to using a non-qualified annuity to stretch the tax deferral benefits over using a traditional brokerage account?
Success in this scenario = higher terminal value (all else equal)
Let’s get started.
I’m assuming the following:
$500,000 initial starting value
20 year time horizon prior to death, then 44 year time horizon after death
6% rate of return on a 60/40 portfolio
To account for tax drag in the brokerage, the equity portfolio has a dividend yield of 2.19% (of which 70% of dividends are qualified and 30% of dividends are ordinary), the fixed income portfolio has a yield of 3.97% - this tax due relative to the portfolio amount accounts for 0.61% so I reduced portfolio return by this amount annually (5.39%/yr)
Distributions beginning at $10k after taxes adjusted for inflation at 3% over years 1-20.
At death, the beneficiary is age 45 and the first distribution is based on a Uniform Lifetime table value of 41 (then adjusted for inflation moving forward). Brokerage account distributions are the same as the NQ annuity to keep distributions the same.
Beneficiary death ends at 85 (44 years after first death)
Fees are the same
Tax rate = 24% (ignoring state taxes in this example)
Captain gain rate = 15%
Inflation is 3%.
NQ Annuity value prior to death = $1,581,171 (of which $1,081,171 is gain)
Brokerage account value prior to death = $1,407,985 (of which $907,985 is gain)
No surprise the tax deferral of a NQ annuity provided a higher value prior to passing.
But when you adjust for taxes paid, you get a different story.
After passing, the brokerage account basis gets a step up in basis to fair market value - which completely eliminates the tax due on the gain for the beneficiary.
Assuming our 15% capital gains tax rate, this means the beneficiary with a brokerage would save $136,197 while the embedded tax liability of the NQ annuity would be $259,481.
This leaves the ending values at first death (accounting for taxes) would be:
NQ Annuity = $1,321,689
Brokerage = $1,407,985
Granted, this wouldn’t be the starting value for the NQ annuity (because you’re getting to defer that tax bill) but provides us with a reference point at first death (that the brokerage account is superior at this moment in time).
With the beneficiaries now inheriting this asset, the NQ annuity stretch distribution would be $38,670 (derived from the ending value of $1,585,506 divided by the uniform lifetime table value at age 45 which would be 41).
The NQ annuity does not get a step up in basis and all of the growth is taxed at ordinary income.
As we stretch out the timeline until age 85, we see the following:
NQ Annuity value after first death = $20,647,528 (of which $20,147,528 is gain)
Brokerage account value after first death = $14,229,527 (of which $13,729,527 is gain)
After taxes we see the following:
NQ Annuity after first death & ordinary income tax due on growth = $15,812,121
Brokerage account after first death & step up in basis (no tax due) = $14,229,527
What does this tell us?
Under a long enough time horizon, the NQ annuity can have its place.
The break even occurred between years 49 and 50.
Where the brokerage account was more favorable prior to that point & the NQ annuity tax-deferral benefit outpaced the brokerage tax-efficiency after that point.
This does raise the question regarding how disciplined an investor (& investor’s beneficiary) would be to wait a 50 year period to see their capital allocation decision pay off.
While I didn’t perform a sensitivity analysis to see how each variable impacted the ultimate outcome, I have confidence in the direction it would change the outcome but not the specifics, outlined as follows:
Higher tax rates would favor the NQ annuity (lower tax rates would favor brokerage, because then gains could potentially be realized at a 0% - 10-12% marginal federal tax rate permitting)
Rate of return would favor the NQ annuity (lower returns would favor brokerage)
Higher fees in the NQ annuity would make the brokerage more favorable (& vice versa)
Longer time horizon favors the NQ annuity, shorter time horizon favors the brokerage.
Less tax drag favors brokerage account, more tax drag favors the NQ annuity
Higher starting account value would favor NQ Annuity (more compounded tax deferred growth) & lower account value would favor brokerage.
All in all:
I’m surprised by the outcome.
I thought the step up in basis with capital gains would blow the NQ annuity’s lack of step up in basis & ordinary income rates out of the water - I’m most surprised at the power of compounding of the tax-deferral.
I guess that’s why Albert Einstein called compounding the 8th wonder of the world.