Municipal Bond Funds
These funds are an attractive option for retirement savings. The income they produce is exempt from federal and in many cases state income tax (although the sale of the bonds may result in taxable capital gains or losses, and some municipal bonds may be subject to the alternative minimum tax).
If a municipal bond fund’s average yield is 3 percent, the equivalent taxable yield is almost 4.3 percent if the investor is in the 30 percent personal tax bracket. Investors can withdraw money from a municipal bond fund at any time without a tax penalty. A drawback of municipal bond funds as compared with annuities is the lack of a guaranteed return (bond rates may go down in future years, resulting in a lower yield on reinvestments of interest and matured bonds), and the potential for capital losses (if interest rates rise and bonds must be sold before maturity).
Single Premium Life Insurance (SPLI)
This type of life insurance offers many of the same advantages of annuities, but incorporates a death benefit at issuance that is higher than the cash deposit (whereas, for annuities that contain a death benefit feature, the guarantee is usually equal to the amount of the cash deposit). However, there are important differences between an SPLI policy and other types of life insurance.
Generally, no income tax or penalties are payable until or unless the owner surrenders the policy. However, single premium life insurance policies issued after June 21, 1988 generally are modified endowment contracts (MECs). Distributions from MECs are taxed under essentially the same rules as annuity contracts. This means that owners will be taxed on any policy distributions, including loans, at the time received to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract. Additionally, a 10 percent penalty tax may apply to certain distributions. In effect, the MEC rules remove the tax-free borrowing possibilities otherwise associated with life insurance policies.
Planners should not direct a client to a product—any product—merely for its tax advantages, because these are at the mercy of a voter-conscious Congress, as demonstrated by the effect of legislation passed in 1988 on SPLI, discussed above (although Congress generally provides some level of grandfathering provisions for most tax law changes, as it did for the new MEC rules in 1988). Certainly, if a client does not need the leverage that life insurance provides, the costs and restrictions make SPLI less attractive once one considers the cost for the death benefit which reduces the capital available for investment growth.
Mutual Funds
During the accumulation period, variable annuities offer investment options that essentially are the same as mutual funds. Mutual funds do not enjoy the tax-deferred accumulation associated with variable annuities. However, under recent tax rules, tax on the capital appreciation of the assets in a mutual fund is deferred until the gains are realized. In addition, the realized gains are taxed as either long- or short-term capital gains, depending on the holding period. In contrast, all gains and income on the assets in the separate accounts of a variable annuity are taxed at ordinary income tax rates when paid. Also, under recent tax rules, mutual funds receive a step-up in basis at death in the hands of the heir. There is no step-up in basis in annuity values in the hands of the beneficiary when the annuity contract owner dies. The as-yet-untaxed income in the policy is treated as income in respect of a decedent and is taxable to the beneficiary as ordinary income when paid.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM