Keel Point Insights

Optimizing After-Tax Return with Private Placement Insurance and Annuities

Keel Point has partnered with Lombard International and Republic Capital Group to offer eligible clients private placement life insurance and variable annuities where we believe they can improve after-tax investment results. To decide if there is after-tax improvement to be had, we need to understand how these structures work and then construct a model of costs and benefits. And in recognition of the spectrum of situations out there, we must also understand how certain key assumptions impact the results of our modeling. While the prospect of math in the August heat might sap your interest, we encourage you to follow along – this is an important opportunity to potentially keep more of what your investments earn.

But before we begin, a quick reminder that Keel Point does not give tax advice to its clients. While we consider a spectrum of situations, your specific situation is assuredly different and should be discussed with a tax advisor. Also, there are certain minimums and eligibility requirements for these products. In particular, clients must be accredited investors.

First, the “less math required” opportunities. We encourage anyone who has an existing annuity to talk to their Keel Point financial advisor. There may be an opportunity to exchange to a private placement variable annuity with our partner at better terms and without paying tax on the transfer (1035 exchanges). Second, anyone with a set-aside bucket of assets for charity should consider the annuity structure. If there is a charitable beneficiary, income tax at the back end would go to zero, thus making the annuity structure preferable to an existing taxable account in many situations. Now, on to more complicated cases, presented as simply as possible.

Private Placement Variable Annuities

The variable annuity structure creates an IRA-like entity for growing wealth. Inside the annuity, no taxes are due on capital gains or income generated by the investments. When an owner starts to take distributions from the annuity, gains above the policy basis (i.e. gains above contributions to the annuity) are taxable at ordinary income rates. Like an IRA, there is a 10% tax penalty if an owner takes distributions prior to age 59 ½. The risks to this structure (and the life insurance structure) are similar to the risks you face in a typical investment account, but also include the risk that tax law or regulations will change (please see an offering document for a complete list of risks).

The structure works to increase wealth so long as the net tax savings (taxes saved less the annuity fee) internal to the structure grow enough to offset the income tax due on distributions from the annuity. Let’s walk through a simple example. For purposes of the example, we assume you pay the highest Federal tax rate of 40.8% (includes the Affordable Care Act tax) but live in a state with no state-level income tax. We also assume that your tax rate doesn’t change, although it may be lower after you retire.

You have the opportunity to invest in an alternative investment that you expect to generate 6% a year, net of any investment management fees, on average. This investment is not tax efficient – 100% of earnings will be taxable to you at your marginal income tax rate. If you make a $1,000,000 investment in a taxable account, your net-of-tax, take-home earnings are $35,520 ($1,000,000 * 6% * (1 – 40.8%)).

The same investment in an annuity structure avoids the tax internally but pays an annual fee and tax when gains distribute. At an annuity fee of 0.5%, annual earnings internal to the structure are $55,000 on average ($1,000,000 * (6% – 0.5%)). However, accessing the capital would trigger taxes on the gains at your marginal income tax rate. If distributed, your gains are roughly $32,560 ($55,000 * (1 – 40.8%)), less than what was achieved in a taxable account.

So, we need some time for the savings internal to the structure (the difference between the $55,000 earned in the annuity and $35,520 earned in the taxable account) to compound to make this work. Figure 1 shows how the math changes over time.

The blue line shows the post-tax return generated by a taxable account holding the investment. Since we assume the same pre-tax return and no change in tax rate, your annualized post-tax return is always 3.6% no matter the length of your holding period. The green line shows how the net tax savings internal to the annuity structure compound to improve your result at liquidation. We start with $32,560 (or 3.3%) if liquidated after year one and grow to 4.3% annualized if liquidated after year forty. The lines cross at year ten, at which point the annuity is a better deal.

This analysis is sensitive to two key variables – the pre-tax return and profits consumed by taxes. We picked the example because we thought it was realistic, but we want to show how the analysis would change if these two key variables were different. We hold one constant and allow the other to change to isolate the latter’s impact. The tables below show these results in terms of crossover years – the first year that the annuity, if liquidated, is worth more to you than a taxable account with the same investment.

Table 1 identifies the impact of the assumed portfolio return. Lower returns imply lower net tax savings so crossovers take more years to achieve. For instance, a portfolio of bonds like those owned in the Barclays Aggregate Bond Index, currently yielding 3%, is not a good candidate here as the crossover point is more than thirty years away. However, a portfolio of tax-inefficient investments that you think will earn 8%would cross over in just six years under these assumptions.  

 Table 2 details the sensitivity of the analysis to the tax rate. Like lower returns, lower tax rates generate less tax savings potential and thus annuities require more time to compound to a better result. For example, a more tax efficient investment that generates 6%, but at long-term capital gains rather than income rates, would cross over in twenty-four years. However, many of you live in states with taxes on top of the 40.8% Federal rate we used in our initial example. California residents in the highest bracket face a 54.1% rate which generates considerable tax savings and a crossover at the eight year mark. 

Private Placement Life Insurance

Private placement life insurance offers features similar to the annuity product, but with a few important differences. First, there is a death benefit attached which means clients will go through an underwriting process. The policy can allow for tax-free withdrawals up to the basis of the policy and tax-free loans on gains but needs to be structured a certain way to do so. Last, the value of the life insurance assets can be passed tax-free to heirs at the insured’s death conferring potential as an estate planning tool.

The crossover analysis here is potentially simpler. Assuming the structure is set up for tax-free liquidity, we have eliminated the need for net tax savings to compound over time for the strategy to work. Instead the calculation is more straightforward. Which amount is greater – a) the expected annual tax owed on an investment in a taxable account or b) the annual all-in cost for the life insurance product (which depends on your age, sex, etc.)? If a) is greater, which is more likely with higher returning, less tax-efficient investments, life insurance might make sense. This comparison does assume that growth rates outpace loan interest once liquidity must come in loan form.

There is potentially more to consider than our simple examples here (e.g. the impact of volatility), but hopefully this serves to guide the decision-making process. Our generalized conclusion is that long-term investors have a chance to come out ahead with these products. Alternative investments, in particular, are tax inefficient assets that may offer high enough returns to compound net tax savings to greater wealth. We encourage you to explore the opportunity with your Keel Point financial advisor.□

This material is distributed for informational purposes only.

The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this re-port are obtained from what we believe to be reliable sources including Eaton Vance and The Wall Street Journal, but their accuracy, completeness or reliability cannot be guaranteed. An index is an unmanaged weighted basket of securities generally representative of a certain market or asset class. An investment cannot be made directly in an index. Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. No conclusion should be drawn from any chart, graph or table that such illustration can, in and of itself, predict future outcomes. You may request a free copy of Keel Point’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.

Past performance is not an indication of future returns.

Securities offered through Keel Point Capital, LLC, Member FINRA and SIPC. Investment Advisory Services are offered by Keel Point, LLC an affiliate of Keel Point Capital. Keel Point does not give tax, accounting, regulatory, or legal advice to its clients.  The effectiveness of any of the strategies described will depend on your individual situation and on a number of complex factors.  You should consult with your other advisors on the tax, accounting, and legal implications of these proposed strategies before any strategy is implemented.