When it comes to investing, the wealthy are intensely concerned about fees and after-tax investment returns. They want to avoid situations where they achieve a significant investment return only to lose a substantial portion of the upside to taxes and other expenses.
In today’s environment, high-income earners are dealing with top tax rates of 39.6% for income taxes, 20% for long-term capital gains taxes and 3.8% for the net investment income tax (NII, also called the Obamacare tax). On top of that, many people have to pay income taxes to their states and, in some cases, their cities.
Of course, paying more in taxes on an investment portfolio that has meaningfully appreciated is a “high-class problem” that many investors would be happy to have. That said, there are a number of ways for investment professionals to flexibly manage investments and still mitigate taxes, thereby delivering potentially superior results.
One way to achieve this is through a custom private placement annuity.
These are annuities that essentially incorporate the investment philosophy and approach of a registered investment advisor. It has the characteristics of a deferred annuity, but the underlying portfolio is managed by the investment professional who set it up.
A Case Study
Let’s look at one example of how an advisor used a private placement annuity for a wealthy client. In this case, the advisor has a client with $30 million in liquid assets looking to take advantage of compounding by leveraging tax deferrals.
Turning to private placement annuities, the advisor projected the performance of a custom annuity versus a taxable discretionary account for the 50-year-old male client (Figure 1). On an initial investment of $10 million, at five years the annuity outperforms the discretionary portfolio by slightly more than $1 million. With the power of compounding, the difference is about $3 million after 10 years, nearly $10 million after 20 years and more than $20 million after 30 years. If the wealthy client lives past age 90, as his grandmother did, the difference approaches $50 million.
In this example, the annualized returns after taking out investment fees are 6%—what the advisor has been achieving, on average, for the past five years. Also, the portfolio has a turnover of about 50%. The fee for the annuity wrapper is subtracted from the returns of the annuity. A total blended tax rate of 36.75% was used for the taxable portfolio.
There are advantages and disadvantages to private placement annuities that advisors need to consider. Unlike a discretionary account, a custom private placement annuity does not produce an annual tax bill. Also, unlike other private placement solutions, the custom private placement annuity is relatively easy for affluent investors to exit, meaning the owner can cash out if investment performance is substandard or cash is needed.
While moving money into or out of a private placement annuity is relatively easy, this flexibility carries a price. There’s a 10% excise tax on deferred investment gains if clients take out money before they are 59½ years old. Also, in perhaps the biggest drawback for wealthy investors, money taken out of a private placement annuity is taxed as ordinary income.
In this case, the custom private placement annuity has been integrated into the wealthy client’s estate plan. It is part of a charitable giving strategy that offers the option of accessing money in the annuity if it’s needed. By making a not-for-profit the beneficiary of the private placement variable annuity, all the deferred investment gains are tax-free when the client passes away. Yet even if the client bequeaths a private placement annuity to a not-for-profit, it remains under his ownership and control until death, providing considerable planning and financial flexibility. There are also very sophisticated ways for the wealthy to combine custom private placement annuities with charitable trusts, generating financial benefits for all parties.
The case study is only intended to be illustrative and provide some perspective on the differences between the two ways of investing. Different investment returns and tax scenarios can meaningfully impact bottom-line performance.
It should also be noted that custom private placement annuities are not for all wealthy clients. They are most appropriate for clients with long-term investment horizons, who are comfortable with their assets sitting in the annuity for many years. Furthermore, these annuities—like any significant assets—should be part of a wealthy client’s overall estate plan. They are also good tools for philanthropically motivated clients.
Frank W. Seneco is an advanced planning life insurance specialist. He is the president of Seneco & Associates Inc., a boutique advanced planning firm in Connecticut. He can be reached at fseneco@seneco.com.
