Email this article Format for printing

Interview With a Financial Planner, Part Two
Estate Planning, Life Insurance, Annuities

In Part 2 of my interview with Joel Kantor, a Certified Financial Planner in Tulsa, Oklahoma, we discuss the process of planning your estate and the benefits (or lack thereof) of life insurance and annuities. Ultimately, it's hard work and patience that provide your portfolio with the return you need to meet your goals. As investors, we need to leave ourselves as many options as possible.

By Barbara Eisner Bayer (TMF Venus)
August 23, 2000

Last week we learned the steps to creating a financial plan. Today, Joel Kantor and I discuss estate planning.

Joel Kantor: Estate planning has a threefold mission: 1) passing your accumulated wealth to people of your choice when you die; 2) paying the least amount of taxes while passing on your accumulated wealth; and 3) the balancing act of paying the least amount of taxes today to accumulate the greatest amount of wealth tomorrow, while paying the least amount of estate taxes.

TMF Venus. What steps do you take?

Joel Kantor: From the financial plan, we have the balance sheet and a handle on cash flow and income taxes. Now we prepare for the worst-case scenario -- estate planning, life insurance analysis, and evaluation of wills and trusts to determine if they meet the client's goals. Unfortunately, of the 15 sets of previously prepared estate documents I've reviewed, not one met the client's goals.

TMF Venus: Why not?

Joel Kantor: Trusts can be complex. CPAs know their stuff. Tax attorneys know their stuff. But, they don't necessarily know each other's stuff.

TMF Venus: What about life insurance?

Joel Kantor: My quest is to determine how much life insurance a client really needs and what type it should be.

In my opinion, life insurance isn't an investment, but a tool to fund unfunded goals like education, retirement, and lifestyle continuation for a spouse in the case of an untimely death. Life insurance can also be used for estate liquidity needs, bequests, and other charitable contributions. I analyze how much life insurance you need (or don't need). Because I don't sell it, my advice comes without the burden of improving or hurting my paycheck.

TMF Venus: What about annuities?

Joel Kantor: There are two kinds of annuity investments, fixed and variable.

Fixed annuities are like certificates of deposit (CDs) offered by insurance companies. The early withdrawal fee/penalty from a brokered fixed annuity will be even greater than on CDs. On the positive side, tax planning can be accomplished by using an annuity to push income from this year into next year, lowering income for tax purposes (a good thing).

But, once you own them for more than a year, your flexibility drops off the planet. Too many people allow the unpaid tax or expense penalty to handcuff them into holding the annuity, missing wonderful investment opportunities. In the 19 years I've been managing money, I've seen this happen too frequently.

A variable annuity is an insurance wrapper around equity mutual fund investments. You pay an extra 1% to 1.5% (or more) annually for your equity fund never to be worth less than your original investment should you die prior to withdrawing the money. Is it worth it? For the most part... no!

If you'll need the money in such a short time as to not let the stock market go through its normal cycles, equities are not the place to invest. If you have long-term investment capital, which qualifies to take the risk of the stock market, you don't need to insure it.

Additionally, why would you want to throw away today's best tax dodge -- long-term capital gains? Why turn it into ordinary income?

Great salespeople hawk annuities. I knew two brothers who worked for Hartford Life. They'd tell stories about their dead grandmother that brought the crowd to the edge of their chairs. People were hearing, "Invest your money while you're young and watch it grow." Then, when you retire and are in a lower tax bracket, "Sell it to generate income without incurring any capital gains tax." At first, even I thought it was a great tool.

I turned sour when I realized that it wasn't what they were saying that was important, but what they were not saying. The greatest damage occurs when you die owning an annuity. For example, let's say you're 45 years old, and you put $250,000 in a variable annuity and $250,000 in a standard Foolish Four. Your variable annuity grows at an average 12% annually. Your Foolish Four also grows at 12%, but you had to pay tax of 20% each year. The actual rate after-tax was 10%.

In 25 years, it's time to meet your maker. The annuity is worth $3,794,657, while your Foolish Four portfolio is worth only $2,256,282. Wow... the annuity is worth $1,538,376 more than the other portfolio! That's no small difference. But, which portfolio do you think will be the largest after estate taxes?

It isn't the annuity! Let's assume that these two portfolios don't escape the unified credit (the portion of your estate that's free from estate tax). The Foolish Four portfolio will pass to the heirs, less 50% estate tax or $1,128,141. No capital gains tax because your beneficiaries' cost basis would be stepped up to the value of the stocks as of the day you died.

But, the annuity might only be worth $125,000. How did I get that?

The estate paid half of the value of the annuity in estate tax, $1,897,328. Then, the beneficiaries inherited the annuity and had to pay half of the gain in ordinary income tax ($3,794,657 - $250,000 x 50% = $1,772,328). Thus, $3,794,657... less the estate tax of $1,897,328... less the income tax of $1,772,328... leaves $125,000.

(For simplicity's sake, this example does not include many other factors to consider when investing in annuities. For more information, see the Fool's School series on annuities.)

TMF Venus: If you're saying that the Foolish Four will be worth $1,128,141, while the annuity would only be worth $125,000, that's shocking!

Joel Kantor: Mostly. My example was a worst-case scenario, though. Check with your CPA and she or he will tell you how the "income in respect to decedent" rules work to get the estate tax as a deduction to the income tax calculation. (In round numbers, half of the estate tax equals $1,897,328 / 2, or $984,664.) Keep in mind, each person's estate and income tax situation will be unique, and this scenario used the highest tax brackets. But it's still less than the equity portfolio.

I'm not anti-annuity (even though I hate them and they're a pain in the neck). I'm anti-bad investment. When the investment doesn't fit your circumstances, stay away from it. The key to annuities is to not die with one. Make sure you use it before your time is up.

There are no get-rich-quick schemes without the risk of also investing in a get-poor-quick scheme. Hard work and patience will ultimately provide your portfolio with the return you need to meet your goals. As investors, our goal is to leave ourselves as many options as possible.

* * *

Part 3 on Thursday: Fee-structure, and finding a planner who's right for you.

Will David Bowie triumph over Suze Orman and a chimp? Play Fool Survivor and you could win $2000 or a Handspring Visor!

Related Links:
Annuities: Buyer Beware, Retiree Report, 8/21/00
Insurance Introduction, Fool Personal Finance

 See Also