Friday, March 29, 2024
Home Authors Posts by Charlie Gipple, CFP, CLU, ChFC

Charlie Gipple, CFP, CLU, ChFC

101 POSTS 0 COMMENTS
Charlie Gipple, CFP®, CLU®, ChFC®, is the owner of CG Financial Group, one of the fastest growing annuity, life, and long term care IMOs in the industry. Gipple’s passion is to fill the educational void left by the reduction of available training and prospecting programs that exist for agents today. Gipple is personally involved with guiding and mentoring CG Financial Group agents in areas such as conducting seminars, advanced sales concepts, case design, or even joint sales meetings. Gipple believes that agents don’t need “product pitching,” they need mentorship, technology, and somebody to pick up the phone… Gipple can be reached by phone at 515-986-3065. Email: cgipple@cgfinancialgroupllc.com.

The #1 Social Security Mistake I See

I think almost every financial professional should be somewhat astute with Social Security. After all, Social Security is one of the very few things that almost all of our prospects and clients will have in common from a financial standpoint. Almost every one of them will be filing for their Social Security benefits eventually, and therefore doesn’t it make sense for all of us to be able to field those questions if they come up?

I know there are some folks that believe that wealthy clients do not care about optimizing and maximizing their Social Security. That may be true for some of them, but I will say, when our agents and I conduct Social Security seminars, if we have 20 consumers in a room a few of them will be millionaires. So, although I do agree that the ultra-wealthy may view Social Security as a rounding error in their overall portfolios, I would adamantly say that there are plenty of affluent consumers that do care about optimizing their Social Security.
With that, I wanted to share with you the number one mistake that many consumers make or intend on making when it comes to filing for Social Security. This mistake is purely because of their misunderstanding of how Social Security works.

First off, let’s step back and talk about “Delayed Retirement Credits.” We all know that when you delay filing for Social Security retirement benefits past full retirement age, you get a .66 percent increase per month that you delay past that point. So, that comes out to be eight percent per year in delayed retirement credits. This means that if my full retirement age is 67, then by delaying until age 70—which is the latest I can delay while getting delayed retirement credits—then I will have a 24 percent increase on my Social Security benefit permanently! In a time where everybody is living longer, if you do the math over your expected lifespan, delaying often makes sense. (Note: Good Social Security software will calculate and compare the total amount of Social Security benefits you would get over various “lifespans” and different filing dates.)

So, where is the mistake that I see many consumers make or intend to make (until they speak with me)? It has to do with spousal benefits. What I just explained regarding delayed retirement credits is if a Social Security recipient is going to be taking Social Security based off of their own earnings record. However, if you are in a situation where you are taking spousal benefits based off of your spouse’s earnings record, delayed retirement credits do not apply.

Let’s take a 63-year-old couple who is trying to decide when they should file for Social Security. Because they were both born in 1960, we know that their “full retirement ages” are age 67 (per the Social Security tables). He has made a ton of money over his lifetime, and she has made very little. This hypothetical is not Charlie being a stereotypical pig but is actually very common in families—like mine. Oftentimes she has stayed at home with the kids and therefore has not earned much while her spouse continued to work to bring home the bacon! By the way, we all know who had the toughest job, and the most important job. Her! Well, the Social Security administration recognizes this dichotomy and therefore says that if 50 percent of one of the spouse’s full Social Security amount (Primary Insurance Amount) is more than her full retirement amount which is based on her own earnings record, then she can take her Social Security benefits based off of 50 percent of his full retirement amount. For instance, if his full retirement benefit is $3,000 per month based on his earnings record and hers is $1,000 per month, then you can bet that she will be looking to leverage the spousal benefit, which would come out to $1,500 per month. To be clear, I am saying “full retirement amount” to simplify the conversation. Technically, it is the “Primary Insurance Amount,” which is defined as the amount of Social Security benefits one would receive based on their earnings record at full retirement age.

So, for our 67-year-old couple it is a common strategy for him to delay filing until age 70 in order to get that 24 percent step up in his benefits. If his “Primary Insurance Amount” was $3,000 (at full retirement age) then by waiting until age 70, he would get $3,720 (not including COLAs) for the rest of his life. It may also be natural for her to also want to delay until age 70 so that she gets those 24 percent step ups on her spousal benefit. She might think that those eight percent delayed retirement credits would be on top of her $1,500 per month benefit. Wrong, Wrong, Wrong.

As I have told several consumers, spousal benefits do not get those delayed retirement credits like they do if it was otherwise based on her own earnings record! Hence, if she delays until age 70, effectively what she has done was left three years of benefits on the table. Again, this is because there is no reward for waiting until age 70 when it comes to spousal benefits. Her spousal benefit at age 70 would still be $1,500 (not including COLAs). Again, she left three years of benefits on the table. Wouldn’t that be a shock to her once she turned age 70 and saw that she only got $1,500?

More than likely, the ideal strategy would be that she files at her full retirement age (67) so that she does not leave those three years (ages 67-70) of Social Security benefits on the table. However, remember that, unless her spouse has filed for his benefits, she does not get the spousal benefit at least until the time comes that her spouse files.

So, because our hypothetical guy won’t file until age 70 in my example, then what benefit will she get between the ages of 67 and 70? The benefit is based on her own earnings record, $1,000 per month (not including COLAs). Then, when he files at age 70, her benefit will bump up at that time to reflect the spousal benefit.

What have you done by alerting this couple that spousal benefits do not get delayed retirement credits? You have allowed her to not leave $36,000 ($1,000/month times 36 months) on the table!

(Note: We will be displaying some great Social Security software that agents can utilize at our Chicago, Des Moines, and Minneapolis Lunch and Learns in November. If this interests you, inquire with us about registering at info@cgfinancialgroupllc.com.)

Independent Distribution: Never Being “Outproducted”

Back in the early 2000s I worked for one of the large career life insurance companies that we all have heard of. This was and still is a great company that I was proud to represent. However, eventually I decided to leave to work with one of the carriers here in Des Moines that were first to the indexed annuity game and distributed all of their products through independent distributors like IMOs and independent financial professionals, like you. That was over 20 years ago, and I have been in independent distribution ever since.

The experience of being “captive” then later being exposed to independence was a very eye-opening experience for me in many ways. Thus, I would like to highlight three areas that I feel were the most significant differences at the time and still are.

The Product Spectrum is Wide and Optionality is Important
When I was a career agent—naïve in my early 20s—I believed that if I was with a fortune 500 company that had been around forever, then almost any product that we offered should be “decent” relative to almost any competitor out there. Afterall, how do you get much better than a mega A+ Fortune 500 company! Boy, was I brainwashed!

Thus, my first observation when I entered independent distribution, and still one of my strongest observations, is this: There is a huge spread between the “worst product” and the “best product” in the world of financial services, even among top rated carriers. Let’s use a simplified example.

Although there is much more to product than numbers/price, let’s take an example of term products and how wide the spectrum is when it comes to term prices. If I punch into my term quote engine that I am a 45-year-old male with a preferred health rating and looking for 10-year term prices on a $1 million death benefit, the worst price is 64 percent higher than what the best price is! That is significant. The ledger that I ran includes about 50 or so life insurance companies that my company offers to our agents. To put numbers to it, the company at the top of my term ledger costs $669 per year and the one at the bottom comes in at $1095 per year. Again, 64 percent difference between the lowest and highest. Am I glad that my agents and I are not stuck representing solely the product at the bottom? Absolutely.

Now the cheapest is not always the best, but in the previous scenario I believe that it is very close to the best. The lowest cost term product is fully convertible—for many years into the future—to a plethora of fabulous permanent products that are also top of their category (GUL for example). Plus, the cheapest term in my scenario is offered by an A+ company and that company will likely provide a great underwriting offer.

To be clear, a product being bad or good oftentimes has nothing to do with the quality of carrier that offers the products. Occasionally, product attractiveness with XYZ company has to do with whether the company even wants to be a player in that product line or not. Great companies may decide they don’t want the lowest term rates, or the highest paying MYGA rates for example. To that point, the company that has the worst pricing in my example above is a fabulous A+ rated carrier that has been around for over a century and is a household name. So again, a carrier having a good or lousy product is not necessarily a function of how good the carrier is. This goes against the belief I had in my 20s that “if I represent one company that is rock-solid then their annuities, life, long term care, mutual funds, etc. must also be of solid value to my clients.”

My point here is, whether it’s the price of term coverage, underwriting situations, guaranteed payouts on annuities, cash accumulation potential on IUL, etc., the spread between the worst and the best is huge. Make sure you have a wide peripheral view of the products that exist. I am very thankful that in independent distribution we have almost the entire world at our disposal.

Technology is Key
Speaking of term quote engines, my second observation is: Technology is key in independent distribution. When you have the entire world of products at your disposal, narrowing down the products based on quantitative items like price or GLWB payout levels on annuities is important. Conversely, if you had access to just one product, very little technology is required. You have what you have!

There are great term quote engines that your IMO can likely provide you with to help you narrow down the prices. There are also great annuity engines out there that let you filter down to the highest paying GLWB annuities, highest caps, highest participation rates, etc.

With optionality of products also comes complexity, at least unless you have good technology to sift through which carriers want to truly be a player in that product line and which carriers offer that product basically as a concession to their distributors.

Again, a good marketing organization/BGA can oftentimes provide these technological tools for you, or at least run the numbers for you.

Product Training and Knowledge
In the previous two sections I spoke largely about numbers, price, payout levels, etc. Naturally, there is much more to these products than just the numbers. Well, “qualitative” is just as valuable as “quantitative” when it comes to most financial products. There is more to it than just numbers. As I’ve said a million times, “Cost is an issue only in the absence of value.” Many times that value is in the various bells and whistles on a product.

In essence, the previous considerations can be utilized as a starting point to identify the pricing dynamics of the products, but then it is important to understand the other items that go beyond the ledgers and quote engines.

Examples of these items might be:

  • Is the term convertible?
  • Will the company give a good underwriting offer? Yes, carriers can differ significantly on various health conditions and the health rating offered.
  • Does the IUL have relatively minimal moving parts? (Loan rates, caps, spreads, bonuses, etc.)
  • Is the whole life policy direct recognition or non-direct recognition?
  • Is the long term care policy indemnification or reimbursement?
  • Does the annuity have any liquidity?
  • Does the GLWB have a nursing home benefit?
  • Although the GLWB payout is great, what is the accumulation potential/death benefit?
  • What is the company’s history with renewal rates/caps/etc.?

These are just a handful of “qualitative” topics for various products that you and/or your IMO should be aware of. Because sometimes the best all-around product may be the cheapest, but sometimes the second or third product from a numbers standpoint is the best.

Awareness around each product’s qualitative components emphasizes how important your training and knowledge is—my third observation. The importance of associating with entities (carriers, IMOs, partners) that will offer you this training and knowledge is just as important as the products and the technology themselves.

Don’t have the time to study all of these features? Then partner with an IMO that is already an expert in these areas and can save you time by pointing you in the right product direction.

If you have the optionality of product, the technology, and the knowledge, you will never be “outproducted” in independent distribution. Although product is just one part of the equation in working with your clients, it is an important part of the equation.

If this article resonates with you, join us at our upcoming Lunch and Learns in Chicago (Nov. 15), Des Moines (Nov. 16), and Minneapolis (November 17). Even if it doesn’t resonate with you, join us anyway! Visit http://www.cgfinancialgroupllc.com/events for details!

RILAs: How Do Insurance Companies Do It?

One of the most popular whitepapers that I have created for financial professionals is titled Indexed Products: How the Watch Is Built. This whitepaper speaks to how insurance companies price fixed indexed products (annuities and life). In this whitepaper, I effectively create an indexed annuity based on today’s interest rates and options prices. I show how the options are bought and sold to create a “cap” of X percent. If you would like that whitepaper, email me and I will get it to you. That whitepaper is a great segue into this conversation on RILAs. However, with or without that whitepaper, this article will still be digestible.

I will not necessarily explain in detail “How the RILA Watch Is Built.” However, I will give you some level of technical details on how it is possible for insurance companies to create a RILA, especially without assessing any additional fees to the client. Afterall, the “there has to be additional fees” response comes up a lot with RILAs.

So, let’s take just one product example. Let’s say we have a RILA that has a floor of 10 percent and a cap of 15 percent. This means that the highest downside is that the client can lose 10 percent and the highest upside is 15 percent. That 15 percent is a great cap in today’s marketplace! When you compare that to one of the top fixed indexed annuities that has a cap of 11.5 percent, 15 percent looks very good! So again, how do the companies do it?

The actuarial logic of RILAs is similar to indexed annuities; bonds support the product guarantees and options provide the upside potential. However, in this RILA product example, we aren’t just talking about call options we are also talking about put options. Let me explain with 100 percent hypothetical numbers while using the S&P 500 as our index…

Let’s start with fixed indexed annuities. With a fixed indexed annuity, following is how they are created. This is a very abbreviated version of the aforementioned whitepaper. Based on the bonds the carrier invests in, we may have a “call option budget” of four percent for our call options. That four percent (of the entire premium) is what we have to purchase the call options. However, the carrier generally doesn’t just purchase call options with indexed annuities, they also sell call options.

With the four percent in the carrier’s pocket, the carrier will buy an “at the money” S&P 500 call option that will give them 100 percent of the upside potential in the S&P 500 over the next year. However, that “at the money” call option may cost seven percent versus the four percent that the carrier had as a call option budget! So, what does the carrier need to do to get their net cost down to four percent? The carrier needs to come up with an extra three percent obviously. That is where the carrier will sell an “out of the money” call option that gives the upside beyond the “out of moneyness” to somebody else. In our very hypothetical example, a call option that is “out of the money” by 11.5 percent is what the carrier will sell, because that is where they can sell the option for around three percent of the “notional value.” (Note: Again, these numbers are not accurate based on today’s options pricing, but it is the concept that matters.)

So, what the carrier has just done was buy one call option that gives them the growth on the S&P 500 up to infinity from today’s S&P 500 value. However, because buying this one option was too expensive, they also had to sell an option that gives somebody else the upside potential beyond 11.5 percent. This is how an indexed annuity is made that has an 11.5 percent cap. The more “out of the money” the option is that the carrier sells, the higher the cap will be to the client. However, the more “out of the money” the option is that is sold, the less the option premium will be that the carrier will get back. So, in this example, the carrier finds that the amount “out of the money” to get three percent back is indeed 11.5 percent. Our cap of 11.5 percent is created.

For the options folks, what I just explained above was a “Call Option Debit Spread” where the net cost/debit was four percent of the notional value/client’s premium. For the folks that are not options-savvy, that last sentence never happened!

Now, with my RILA example that has a very large cap of 15 percent, how can this be done without additional fees? First, they would do almost exactly as I discussed with the indexed annuity, where they bought and sold call options to net out to a certain call option budget. However, they would have a call option budget higher than four percent, perhaps six percent! Thus, by having a six percent call option budget, they are able to buy a cap that is 15 percent, instead of 11.5 percent.

Where did that extra two percent budget for our call options come from, especially since the insurance company is not applying an extra fee to the client? With RILAs, the carriers are able to supplement their call option budget by selling “Put Options.” Put options—when bought—give somebody money when the market falls. If you bought a put option on the S&P 500 and the market lost 20 percent, you are likely going to get paid—especially if you bought an “at the money” put! A put option is the opposite of a call option. But you can also sell put options so that when the market tanks, you have to be the one paying the counterparty the amount the market has dropped (below the strike price). Why on Earth would you sell a put option? For the option premium. Like selling anything else, you get money in exchange for it. With options, this money is called the “premium.”

So, what the company did with our hypothetical product that has a -10 percent floor and 15 percent cap was, they sold an “at the money” put option on the S&P 500. By just doing this, the insurance company got a great “premium” for selling this to somebody else (investment bank for example). However, by the carrier just selling this “at the money” put option, this means that the insurance company/consumer would now be 100 percent exposed to the market should it fall. We don’t want the client to be 100 percent exposed; only 10 percent exposed. So, the carrier will then purchase a put option that is 10 percent “out of the money.” This means that somebody else participates in the market’s loss beyond 10 percent. This is how the floor of -10 percent is created.

The put option that the carrier sold was two percent more expensive than the option the carrier purchased. This is because they sold an option that was “at the money” and they purchased an option that was “out of the money.” So, by doing the above selling and buying of put options, the carrier garnered an additional two percent that then gets added to the call option budget that allows them to buy a very high cap of 15 percent. All at the cost of exposing the client to the downside of -10 percent.

In short, by the client being exposed to the 10 percent downside, the insurance carrier is able to afford options that give that same consumer 15 percent to the upside. The carrier did all of this without adding an additional fee to the client.

For the options folks, with RILAs the “Call Option Debit Spread” is supplemented by a credit that the carrier has created via a “Put Option Credit Spread.” Again, for folks that are not familiar with options strategies, move that last sentence to the trash bin of your memory.

A Little About “RILAs”

Much of what I write about is derived from what I hear from the hundreds of agents that work with my company as their IMO. With that, something that has come up a lot in recent months from many of my agents is the topic of RILAs, or Registered Indexed Linked Annuities. The two questions I get on these products are:

  • What are these products?
  • What are the additional fees?

What are RILAs?
This article is not intended to be a comprehensive training on RILAs as there are product variations beyond the scope of this article—different indexes, inverse strategies, various crediting segments, etc. Rather, this article is designed to give those that come across these products enough knowledge to at least know what they are looking at.

RILAs can also be called “Structured Annuities.” For the last decade or so, RILAs have been the top area of growth in the variable annuity business as RILAs have gone from basically non-existent to approximately $40 billion in sales in the year 2022. RILAs now take up around 40 percent of the entire variable annuity business. Although $40 billion is still relatively small compared to the $310 billion (2022) overall annuity business, the growth of this product line has been outstanding and will continue to be.

These annuities very much resemble indexed annuities where they are linked to some sort of an index, they have some level of downside protection, and most of the time have no explicit fees. This is very different than traditional VAs that invest the clients’ money in various subaccounts/mutual funds that can come along with significant fees (subaccount, M&E, rider). There are certainly more similarities between RILAs and fixed indexed annuities than there are between RILAs and traditional variable annuities.

What about the differences? A few of the differences between RILAs and fixed indexed annuities are:

  1. It is possible to lose money with most of these products, versus an indexed annuity—where you cannot get a negative return. For example, one such product has a floor of -10 percent, which means you can lose up to 10 percent of your money. (Note: there are products that have zero percent as a floor. Many times, you can choose your floor.)
  2. As a trade-off to being able to lose some money, the caps and/or participation rates are generally higher than what you see in the indexed annuity world.
  3. These products are registered as securities because of the fact that you can lose money on them. This means that only reps that have a securities license can sell these products.

Although there are various flavors of RILAs as well as many different options within each RILA, to simplify it I would break RILAs down into two main categories—those RILAs that have “floors,” and those RILAs that have “buffers.”

For those that have a floor, the floor is the maximum amount a consumer can lose. Some RILAs give you various options on the level of floor that you would like. Generally, the more money the client can lose, the higher the cap/par rate is. For example, one option may be where you have a floor of -10 percent and have a cap of 15 percent. This means that if the market drops 15 percent, you only lose 10 percent. However, if the market goes up, you can get up to 15 percent. There may be another option in the product that has a floor of -20 percent. So, you have the possibility of losing more money if the market should tank but this generally means that you would have a higher cap, 20 percent as an example.

Instead of a floor, there are RILA options that provide buffers. A buffer means that if the market drops, then the insurance company absorbs the first X percent of that drop. Then, anything beyond that buffer, the client will participate in. For example, if a client has a 10 percent buffer but the market drops 15 percent, the client will only experience a five percent loss. The higher the buffer is, the less the cap/participation rate is to the upside.

What are the additional fees?
When I explain to my agents how the products work and also that they are a subcomponent of variable annuities, they always respond with, “There have to be fees attached to these…” Also, when an agent sees a cap of 15 or 20 percent, they are taken aback because fixed indexed annuities have caps of 10 to 12 percent today on the high end. So, again, “There have to be fees attached to these…”

My answer to the fee questions is: There generally are no explicit fees associated with these annuities, just like how fixed indexed annuities have no fees. (Note: Exceptions are when a certain strategy might have a “strategy fee.”)

The next response is, “Then how are the insurance companies able to do this?” This is where I will refer you to my other article in this month’s edition entitled, RILAs: How Do Insurance Companies Do It?

A Simple Way To Analyze Volatility Controls

In the obfuscated land of volatility control strategies, it is hard to determine which are sizzle and which are steak. Now, it is no coincidence that almost any volatility control strategy within a given product is going to “back-test” better than that specific product’s S&P 500 annual point a point strategy. This statement is especially true immediately after the carrier launches that volatility control strategy! This is no coincidence because that is the very reason that a given volatility control strategy is in the indexed annuity or IUL in the first place.

To back up a little bit, the later part of the last decade is largely when these volatility control strategies were created because of the low interest rate environment. The low interest rate environment generating only four percent caps on indexed annuities caused many carriers and index providers to get creative. So, volatility control strategies that were cheaper to hedge–because low volatility equals lower options costs–proliferated. So, the index providers created these “index” offerings, then they flew to Des Moines (the insurance capital) to pitch the indexed annuity carriers on their new index. Some index providers worked hand in hand with the carriers on the development of certain indices that would later be housed in the carriers’ indexed annuities and IULs.

Now it is not like the index providers and the carriers put together a structure of an index and then just happened to look at the back-testing and say, “That actually looks pretty good.” No, the volatility control strategies were actually created because of the back-testing. I had previously used the analogy that the A-10 warthog jet was not a jet that was built and then they put a gun into it. Rather, the gun was built first and then the jet was designed around it. That is analogous to how volatility control strategies were created. Fabulous back testing was the beginning point. The low volatility asset classes and/or low volatility methodologies that performed the best in hindsight is what informed the makeup of the volatility control strategy and thus the makeup of the indexed annuity or IUL. So, after these creations, although indexed annuity caps were three to five percent, voilà! You can now illustrate an indexed annuity with double digit returns!

My problem with this is, as my old friend Jack Marrion used to believe, I believe that, over the long run, if options markets are efficient all strategies within a respective product will perform somewhat the same. That is because all of the strategies within the respective product generally have the same call option budget. (Exceptions to this may be the strategies within IUL and indexed annuities that have multipliers, bonuses, enhancers, etc.) Therefore, I do not do a ton of mental gymnastics when it comes to picking index strategies within one particular product.

The challenge comes when you are comparing indexed strategies from one product to another product. One volatility control strategy within one product may have a participation rate of 300 percent, but when you look at the other product, it may have a volatility control strategy with a 100 percent participation rate. I always get calls from agents asking about how carrier XYZ is able to have such awesome 250 or 300 percent participation rates. I then emphasize to him/her that the higher participation rate is not always the best and can be easily priced if the volatility in the underlying index was basically zero! Afterall, “volatility” to the upside is what can generate the growth on an indexed product! In fact, that higher participation rate volatility control strategy may have less “call option horsepower” that the carrier has applied to it.

So how can you determine how much call option horsepower the carrier has put into that volatility control strategy? Check out the level of the interest rate on the fixed account. This is a very good measurement tool.

Example: Let’s say you have two indexed annuity products where you are reviewing their volatility control strategies in order to pick one for the best accumulation going forward. You would like to get a cursory feel for which annuity product has the best potential for accumulation. How can you get a feel for this? (Hint: The answer is not to just look at the back-casting, for reasons we discussed! You can look at the back-casting, but back-casting suffers from “hindsight bias.”)

  • Product A: A product with a volatility control strategy with a 200 percent participation rate and also has a fixed rate of two percent in the fixed account.
  • Product B: A product with a volatility control strategy with a 100 percent participation rate and also has a fixed rate of four percent in the fixed account.

Assuming all other parts of the two products above are the same (no premium bonuses, etc.), I would likely choose Product B. I would estimate that Product B’s volatility control strategy has twice the call option horsepower applied to it versus Product A. Of course, I would only make my decision after I familiarize myself with the various indices. I would not make my decision solely off what I lay out above, but I would weigh the above very heavily in my decision.\

This method is not perfect. It’s not perfect because some carriers may give teaser rates and caps in the early years and then taper off the call option budget in later years. One carrier may have a premium bonus whereas the other carrier does not. One carrier may have less surrender charges than the other, etc.

Although it may not seem like it, I do like volatility control strategies. I especially liked them when interest rates were so low that the S&P 500 strategies left a lot to be desired. Like anything else, there are good ones and there are not-so-good ones. It is important that you–the agent–know how to analyze them and also that you work with an IMO that knows how to analyze them. I hope this gives you an additional avenue for your analysis.

Free Stock photos by Vecteezy

The IRS“Death Penalty”

Something that I don’t think advisers talk enough about is the “death penalty” that the IRS assesses to the surviving spouse. What do I mean by this? Many times when one spouse dies, the surviving spouse generally gets a tax increase. This is because, once one spouse dies, it is not like the “taxable income” to the surviving spouse immediately reduces by 50 percent. And without a 50 percent reduction in taxable income, that generally means a tax increase to the surviving spouse. The bestselling author of The Power of Zero—David McKnight—discusses this a lot, but in the following paragraphs, I want to put numbers to it to demonstrate the various flow that makes up this “tax increase.”

In the chart below are the 2023 federal tax brackets. As you can see, married individuals filing jointly can have twice the taxable income for a respective tax bracket than what a single filer is allowed for that same tax bracket. What this means is, again, unless the surviving spouse is recognizing taxable income that is half or less than what the couple was getting prior to the death, it will generally be a tax increase. (One exception to this is how Social Security taxation works, but that is for a later conversation.)

Tax Rates 2023

Let’s give a quick example. (Note: This is fairly simplified and is assuming that Bob and Jill are using the standard deduction as a large majority of Americans do.)

Bob and Jill
Bob and Jill are both aged 75 and have a total retirement income of $100,000 per year. Their income is comprised of the following sources:

  • $30,000 (Social Security for Bill).
  • $20,000 (Social Security for Jill).
  • $30,000 (IRA Annuity Payments from a GLWB (Joint Payout).
  • $20,000 (Required Minimum Distributions).

Bob tragically passes away in late December of 2023. What does their joint tax return look like for 2023? We will then compare that to Jill’s tax return for 2024, in order to demonstrate this “Death Penalty.” We will also be assuming the exact same tax brackets and standard deductions in both tax years for simplicity.

2023 Tax Return
(Note: In the year of death, Jill is allowed to file as “Married Filing Jointly” as we do below.)

Income Subject to Tax:

  • $42,500 (85 percent of their Social Security Income that is subject to taxation because they made over $44,000 in Provisional Income).
  • $30,000 IRA Annuity Payments from a GLWB (Joint Payout).
  • $20,000 in Required Minimum Distributions from securities.
    $92,500 (Total Income Before Standard Deduction).

Standard Deduction:

  • $27,700 (Regular “Married” Standard Deduction).
  • $3,000 (Additional $1,500 per person for being over age 65).
    $30,700 (Total Standard Deduction).

Taxable Income:

  • $92,500 (Total Income Before Standard Deduction).
  • -$30,700 (Total Standard Deduction).
    $61,800 (Taxable Income Subject to “Married Filing Joint” Tax Brackets).

Total Tax in 2023:
(Note: Tax brackets are “marginal,” meaning that although Bob and Jill are in the 12 percent tax bracket, not every dollar is taxed at 12 percent.)

  • $2,200 (The first $22,000 of Taxable Income multiplied by 10 percent).
  • +$4,776 (The remaining $39,800 ($61,800 — $22,000) taxed at 12 percent).
    $6,976 Total Federal Tax Due.

Now let’s move on to the 2024 tax return and assume the same income to Jill (except for the Social Security on one life that she will lose). Again, this is simplified because we are assuming the income levels per tax bracket remain the same in 2024, although this is unlikely due to the “inflation adjustments” that occur in most years to the brackets.

2024 Tax Return
Note: This is the year after death and therefore Jill is filing as “Single.” She is not a “Qualifying Widow.”

Income:

  • $25,500 (85 percent Social Security Income Subject to Taxation. Jill inherited Bob’s $30,000 Social Security payment. Jill’s Provisional Income is over $34,000.)
  • +$30,000 IRA Annuity Payments from a GLWB (Joint Payout).
  • +$20,000 in Required Minimum Distributions from securities.
    $75,500 (Total Income Before Standard
    Deduction).

Standard Deduction:

  • $13,850 (Regular “Single” Standard Deduction).
  • +$1,850 (Additional “Single” Standard Deduction for being over age 65).
    $15,700 (Total Standard Deduction).

Taxable Income:

  • $75,500 (Total Income Before Standard Deduction).
  • -$15,700 (Total Standard Deduction).
    $59,800 (Taxable Income Subject to “Single” Tax Brackets!).

Total Tax in 2023:
(Note: Jill is now filing off the “Single” tax brackets. She is now in the 22 percent tax bracket, versus the 12 percent that Jill and Bob were in when they filed “Joint”.)

  • $1,100 (The first $11,000 of Taxable Income multiplied by 10 percent).
  • +$4,047 ($33,725 taxed at 12 percent. This is the entire length of the 12 percent bracket).
  • +$3,316 (The remaining $15,075 ($59,800 minus $44,725) taxed at 22 percent).
    $8,463 Total Federal Tax Due!

Summary:
This scenario is actually more ominous than it looks. You may be looking at the difference in “Tax Due” between the two years as being very minimal. After all, Jill is only paying an additional $1,487 ($8,463—$6,976) in taxes. However, there is more to this story than just that number.

Bob and Jill were previously living off of $100,000 in income coming from Social Security, their annuity with a GLWB, and the RMDs coming from the securities. As far as true “after tax” purchasing power, they were “netting” $93,024 that they could spend on travel, food, etc.

Conversely, after Bob died, Jill was only getting $80,000 in income. This is because she lost her Social Security in order to take the higher of the two—which was $30,000 from Bob. That is how survivor benefits generally work. How much was Jill taxed on the income she was getting of $80,000? More than when she and Bob were raking in $100,000! The above tax increase to Jill after she experienced a $20,000 pay cut is certainly a rude awakening to many widows/widowers. The tax situation can be mitigated by looking at items like Roth conversions and cash value life insurance, as David McKnight discusses.

In the end, between losing one of their Social Security payment streams and the tax increase, this meant that Jill was getting a “net” of $71,537 ($80,000 – $8,463). Relative to what Jill and Bob had to spend prior to Bob’s death, this is a decrease of $21,487 or 23 percent!

There are studies that say that when the spouse dies, the survivor will naturally spend less. I often wonder if that is because the surviving spouse truly has a desire to spend less, or because it becomes a necessity to do so in order to not run out of money. My opinion is, it should be up to the surviving spouse if he/she wants to stop spending. At least giving him/her the option would be nice. How do you provide these options? In addition to a “Tax Free Retirement,” I think a life insurance policy to fund that $21,487 annual gap would be a good starting point… But it has to be earlier than age 75.

Free Stock photos by Vecteezy

Rollovers, Transfers, 1035s: Don’t Assume You Already Know

A client of mine calls me up and says, “My CPA says (oh boy, here we go) that I should have gotten a 1099-R for my direct rollover that we did into my SEP IRA.” I said, “It wasn’t a rollover, it was a direct transfer which does not generate 1099-Rs.” He said, “You are wrong, my CPA said that direct rollovers and direct transfers are the same and both are reportable to the IRS.” I said, “Your CPA is incorrect. Direct rollovers are reportable but direct transfers are not.” A week later he came back and said, “My CPA says you are correct.”

If the above paragraph makes your head hurt, or the more likely scenario where you are questioning if my information is correct, you are not alone. Veterans in the business and even insurance carriers on their forms do not fully understand that there are differences between indirect rollovers, direct rollovers, and direct transfers. Differentiating between “direct” and “indirect” is fairly easy. However, the difference between “direct rollovers” and “direct transfers” is a little more nuanced. However, as my first paragraph demonstrates, it would behoove all of us to take a quick review of these concepts that many folks “think” they understand. There are differences in tax withholding, tax reporting, and logistics. So, following let’s discuss four different ways that consumers can “relocate” their money without a tax liability.

Non-Qualified Money (Non-IRA, Non-401k, etc.):
1035 Exchange: A lot like how Section 1031 in the internal revenue code allows you to avoid capital gains taxes on business property, Section 1035 in the internal revenue code allows you to avoid income taxation on annuities and life insurance. 1035 exchanges are for non-qualified annuities and life insurance that have had the taxes on the growth deferred, whereas if you were to just cash out the policy Uncle Sam will ask for income taxes on the growth. Again, that is only if your surrender value is higher than your cost basis.

However, what happens if you want to move your money from one product to another? Would there be taxes due on the gain? Not if you 1035 exchange that non-qualified money to another annuity or life policy. The cost basis moves over and so does the deferred gain, at least until you decide to completely cash out the money and take “constructive receipt.” Life insurance and annuities can be 1035-ed to annuities. But only life insurance can be 1035-ed to a life policy. You cannot 1035 annuities to life policies. Imagine if you could 1035 a highly appreciated annuity to a life insurance policy that uses life insurance “leverage” that is tax-free! That would be fabulous. Uncle Sam does not allow this.

Uncle Sam does however allow for the appreciated annuity or life policy to be 1035-ed into a hybrid annuity/long term care policy. So, with this concept you can potentially get long term care leverage that is tax free while never paying taxes on the growth that has been deferred! The Pension Protection Act opened up this option for us.

Qualified Money, Including IRAs: Like how we use 1035 exchanges to avoid paying taxes on the gain in the annuity or life policy, we may have qualified money that we want to move without paying taxes on it. Afterall, if all of the money is pre-tax, as it usually is with traditional IRAs, at some point you have to pay taxes on the entire dollar amount. So how do we relocate qualified money that is eventually subject to taxation? This is where rollovers (indirect and direct) and direct transfers come in.

Indirect Rollover: This is when a check is sent from the retirement plan or IRA and made out to the owner. In this case the owner can deposit that money in his/her bank, but that owner has 60 days to deposit it into another plan or IRA. For indirect rollovers coming from an employer sponsored plan such as a 401(k), there is generally a 20 percent mandatory withholding. If the owner does not make up for that 20 percent withholding when they move the money to their new custodian within 60 days, that 20 percent is treated as if it has been withdrawn. Thus, if the person is under age 59 1/2, there is a 10 percent penalty that applies. What makes an indirect rollover an indirect rollover is the fact that the check is made out to the owner where it is then deposited in their account for 60 days or less. Of course, the custodian that sent the money to the owner will issue a 1099-R reporting the disbursement to the IRS. Note: The 20 percent withholding does not apply to IRA accounts (Traditional, Sep IRAs, SIMPLE IRAs) but does generally apply to employer sponsored accounts.

Direct rollover: A direct rollover avoids the withholding issue that one has within indirect rollovers. With these types of rollovers the account owner never actually deposits the check into their account. A very common example of a direct rollover is when you are sitting with a client and they want to rollover their 401(k) funds to an IRA. So, you call the 401(k) with the company that person just left. Usually over the phone, that 401(k) rep can get the details about the new custodian and new account number, then issue a check that is payable to that custodian “for the benefit of” your client. Many times, your client will get the check mailed to them that they then forward to the new custodian without ever depositing the money in his/her account. The check not being made out to the owner is what avoids the 20 percent withholding and the indirect rollover classification. Direct rollovers need to be reported to the IRS just like indirect rollovers, even though the consumer has not taken constructive receipt of the money. Again, this reporting is done on a 1099-R form the custodian will send out. (Note: For indirect rollovers there is a “once per year” rule that does not apply to direct rollovers and direct transfers that I discuss in the following. That rule we will not discuss here.

Direct Transfer: What differentiates a direct transfer from a direct rollover is that direct transfers are transferring among “like to like” accounts. For example, an IRA to an IRA. Conversely, direct rollovers are usually from an employer-based retirement plan to an individual retirement account. Direct rollovers do not have that “like to like” characteristic that direct transfers have. Understanding the distinction between direct transfers and direct rollovers is important around tax time because I cannot count the number of times where I have gotten calls from clients who said, “My tax preparer is saying I need a 1099-R for the direct transfer we did.” Well, for direct transfers, there is no 1099-R that the custodian needs to issue. For direct rollovers, of course, there is a 1099-R required.

You may be confused when I discuss 1099-Rs being issued with rollovers (indirect and direct) that are reported to the IRS. Remember, just because a 1099-R is issued, does not make that transaction taxable. It depends on the “Code” that is indicated on the 1099-R and also depends on if the money hits the doors of the other custodian. When the money hits the new custodian is when that firm effectively “offsets” the 1099-R with a 5498, which reports to the IRS that the money was indeed rolled over.

Long Term Care Linked Benefit Products: Too Good To Be True?

One of the goals that I have as I work for my agents across the country is to guide them on which is the best product for their client’s situation. Impartial and unbiased product knowledge and strategies is what agents want. Needless to say, I analyze a lot of annuity, life, and long term care products. The point is, of a large universe of these products, there are two areas that really excite me today when it comes to product innovation. What are those two areas that excite me the most? It would be a tie between annuities and the topic of this article—linked benefit long term care products.

Too good to be true?
Linked benefit products have gotten so good that many times I get the responses of “Are the benefits really guaranteed?” or “It seems too good to be true.” Skepticism is warranted, because when people think of long term care insurance, they think of traditional LTCI. And with traditional LTCI, many folks have experienced significant premium hikes as the years have gone by. Plus, with traditional LTCI, if you don’t use the benefit, you lose the benefit and the premium you paid. Therefore, the fact that many linked benefit products have 100 percent guaranteed benefits and also have a death benefit and cash value, this creates skepticism among the clients. In this article I wanted to spend a couple minutes discussing why and how the benefits are not “too good to be true” and are indeed sustainable for the insurance carriers to offer. By the way, Traditional LTCI, I believe, is more sustainably priced than previous generations for reasons I will discuss.

First, what is a linked benefit?
A linked benefit long term care product is a subcategory of the broader “Hybrid/Combination Long Term Care” category. What differentiates a linked benefit product from just the products with accelerated benefits (AOB) is that the linked benefits also have a “Continuation of Benefits Rider” or “Extension of Benefits Rider,” depending on the vernacular the carrier uses. Example: Many life insurance policies have AOBs on them where the death benefit—and only the death benefit—can be accelerated for chronic illness or long term care purposes. Conversely, a linked benefit product has the death benefit that can be accelerated (via the AOB) but then, once the death benefit is fully depleted, there is a COB or EOB that kicks in to provide additional long term care benefits. So, with linked benefits you can get multiples of the death benefit in long term care benefits if we are talking a life insurance linked benefit product. With linked benefit annuities you can get multiples of the accumulation value in long term care benefits. The presence of the COB/EOB is what makes a linked benefit product a linked benefit product.

Back to the Question:
Are these products too good to be true? No, they are awesome products but the actuarial logic that goes into these products make them very sustainable to create and price. The semi-actuarial reasons are:

1) Interest rates: This not only goes for linked benefits, but also for traditional long term care insurance. We all know that when an insurance company takes the premium, they put it into their general account, which hopefully grows in value so that the carrier can dip into their general account to pay claims. The higher interest rates are for the carrier, the easier it is to pay claims over time all else equal. Today, interest rates are much higher than they were just one or two years ago. This helps the carriers pay claims! However, this rate environment may not last forever so it also comes down to what are the long term interest rate projections that the carrier is assuming as they price today’s products? Today, carriers have much more reasonable long term projections of interest rates than they did a couple of decades ago. A couple of decades ago carriers assumed fairly high interest rates which allowed for low premiums, at least until interest rates substantially decreased. At that point, the clients got love letters from the carrier saying that their premiums on their long term care policies were going to increase! Today, carriers are much more rational with their long term interest rate projection. So, whether it’s traditional long term care or linked benefits, I believe that premiums are much more sustainable going forward. Besides, with most linked benefit products, the premiums are rock solid 100 percent guaranteed.

2) Lapse assumptions: The best thing that can happen for the carrier with traditional LTCI or linked benefits is that the client pays premium for quite a while (long enough for the carrier to offset the acquisitions costs plus profit) then stops paying the premium and the policy lapses without the carrier ever paying a claim. Once upon a time carriers had lapse assumptions of over five percent. Oversimplified Example: At a five percent lapse assumption, the policies that are written this year will be completely off the carrier’s books over a 20-year period of time. This means that the carrier would be free of any claims on the policies written this year because “all” the policies would be lapsed by year 20!

These overzealous lapse assumptions did not happen! Folks that had LTCI generally held onto their insurance until they went on claim. Even after carriers increased the premiums, clients generally did not lapse their policies. In actuarial terms, the “shock lapse” did not meet the carriers’ expectations. Policy owners were extremely resilient in continuing to pay the premiums, which is a testament to how the consumers valued their policies! So, because very few clients lapsed their policies relative to what was projected to lapse, unfortunately some carriers imploded from their inability to pay claims. Today, carriers are generally assuming that consumers continue their policies until there is eventually a claim and are pricing policies accordingly. This helps with the sustainability of premiums for traditional LTCI and helps the insurance carriers remain financially strong.

3) High deductible: Linked benefit products are very sustainable because they are very similar to high deductible health plans. What do I mean by that? Whether that linked benefit product is an annuity that has an accumulation value or a life insurance policy that has a death benefit, the long term care benefits paid are reducing the client’s accumulation value or death benefit first. The first dollars come from the client’s pocket! For example: Assume a client has a $100,000 death benefit on their linked benefit life policy. They also have a long term care pool of $200,000. If the client goes on claim, the first $100,000 in long term care benefits will reduce the death benefit to essentially zero (residual DBs are usually a part of these policies). That means that if the client were to pass away, then the life insurance policy will not pay out a death benefit at that point (or a very small one). But overall, the client wins because they get up to $200,000 in long term care benefits. Another example: If a consumer has a linked benefit annuity with $100,000 in accumulation value but a long term care benefit of $300,000, the first $100,000 in long term care benefits comes from the client’s accumulation value. Although not technically a “high deductible health plan,” it has a similar trait that allows the carrier to better price this product type.

4) Consumer behavior: With traditional long term care, it is a use it or lose it proposition. Therefore, if the client so much as stubs their toe, they may try to go on claim. A bit of an exaggeration I know. But the clients are very inclined to try to use their policy when they can so they get something out of it. Conversely, with linked benefit products, the client is using their own money at first. This leads to lower claims experience at the insurance carrier for linked benefit products.

Opportunity exists when there is a gap in the need that a consumer has and how much of that need has been addressed. I won’t bore you with statistics around long term care that we all know. What I will say is, when you compare the number of people that will need long term care insurance to those that currently have it, the opportunity for you, the financial professional, is huge.

I hope this article provides you with some confidence and knowledge on traditional LTCI, AOB riders, and linked benefit products. It is now up to you to broach this conversation with your clients.

ChatGPT And I Discuss Estate Planning And Living Benefits: What Grade Would I Give AI?

Created by OpenAI, ChatGPT is one of a few different platforms that people are talking about today. This is a chatbot where you can punch in questions and it will answer you back. This is a class of artificial intelligence that uses “Machine Learning.” Machine learning is where the system basically “learns” and collects data as time goes by. Think of a chess game. If you are a veteran chess player, the history of the moves that the other person takes as well as your predictions on what they will take usually informs us of what our next move should be, based on our history of success with making that next move. If you are a newbie to chess, you don’t have much intuition about your competitor’s previous moves and you have very little prediction powers on next moves. Well, “machine learning” has an almost infinite capability of remembering the past patterns and then drawing inferences into the future. ChatGPT does this not with chess, but with almost any question you throw at it.

What is my verdict on if AI is going to replace the financial professional anytime soon? I will opine on that at the end of this article. But first, feel free to eavesdrop on a conversation between me and AI (ChatGPT).

On my LinkedIn page (have you “followed me” yet?) I recently discussed a bit of a case study where a client came to me and said his dad wanted to either “gift” the farm to him now or wait until after he (the dad) dies to pass the farm on via inheritance. I think this is a great topic to discuss with ChatGPT because it is very nuanced in that there are many things to take into consideration; estate taxes, stepped up cost basis, gift taxes, Medicaid, etc. So, let’s see if the system can hang with us mere mortals.

Without boring you with the nuances of this exact case, my preliminary recommendation without speaking with his dad—as we will—is that the land will likely be better passed on after death rather than via gifting, largely because of the stepped-up cost basis tax treatment. Don’t know what that is? ChatGPT will tell us in a bit.

Now, in hindsight, let’s take the above example and see if my client could have received the same advice that I gave him by using ChatGPT.

My question to ChatGPT:
“Should I gift my assets, or should I wait until I die?”

ChatGPT answer (cut and pasted):

“Deciding whether to gift your assets during your lifetime or to wait until you pass away is a personal decision that depends on your individual circumstances and goals. Here are some factors to consider:

  1. Estate taxes: If your estate is large enough to be subject to estate taxes, gifting assets during your lifetime can help reduce the taxable value of your estate and minimize your estate tax liability. However, it’s important to consult with a qualified estate planning professional to ensure that your gifting strategy is structured in a way that is tax-efficient and meets your long term financial goals.
  2. Medicaid planning: If you anticipate needing Medicaid benefits in the future, gifting assets during your lifetime can help reduce the value of your assets and make you eligible for Medicaid sooner. However, there are rules and restrictions around gifting for Medicaid purposes, and it’s important to consult with an experienced elder law attorney to ensure that your gifting strategy is structured in a way that is compliant with Medicaid rules and regulations.
  3. Control over assets: Gifting assets during your lifetime means that you are relinquishing control over those assets and transferring ownership to someone else. If you want to maintain control over your assets and continue to manage them, it may be better to retain ownership of them until your death.
  4. Gift tax: If you gift assets during your lifetime, you may be subject to gift tax if the value of your gifts exceeds the annual gift tax exclusion amount. However, there are ways to structure your gifting strategy to minimize or avoid gift tax liability, such as using the lifetime gift tax exemption or making gifts to a qualified charitable organization.

Ultimately, the decision to gift your assets during your lifetime or wait until you pass away depends on your individual circumstances and goals. It’s important to consult with a qualified estate planning professional to assess your options and develop a comprehensive estate plan that meets your needs.”

I would give ChatGPT’s response a grade of about a D. Afterall, it didn’t even discuss the notion that when one inherits property upon death, the cost basis “steps up,” which can ultimately lead to less taxes later on. However, if you ask ChatGPT specifically about “stepped up cost basis,” it does a very good job of explaining what it is.

I do like that it brought up Medicaid planning! If assets are gifted today, then the dad may be able to qualify for Medicaid later on. Of course, there is a five-year lookback to take into consideration but at least ChatGPT showed us Medicaid as an item to take into consideration. I also like the fact that it teased on the “annual gift tax exclusion” as a way to gift assets!

My verdict? I want to split my verdict into three areas:

  1. Recommendations: When a client wants to get down to brass tacks on recommendations, the system does not (yet) cover all the bases that need to be taken into consideration. The peripheral vision when it comes to financial advising is not on par with a seasoned professional. Again, for our purposes, I would give it a D grade.
  2. Fine Details: When I asked the system, “What is stepped up cost basis?” it knocked the ball out of the park. Like I mentioned, it does a very good job of explaining what something is, but so does Google. However, I did ask the system about other topics like estate taxes, etc., and it did OK. In this area, I give the system a B+. As time goes on, the “machine learning” will make it more precise.
  3. General Knowledge/Marketing: For this, I give it an A! Not an A+, but an A. I think ChatGPT makes a good living/breathing brochure! This is where you—the financial professional—can save a significant amount of time via articles, blogs, teasers, social media posts, etc. I have begun to do this with my clients while always making it clear that the article was “Powered By AI.”(Sidenote: I do fear that AI will make the writings in our world less “genuine.”)

Anyway, you be the judge of its effectiveness below as I take a random topic of living benefits on life insurance. Is this an article you would find worthy for general education? I think so!

My question to ChatGPT:

“What are living benefits on life insurance?”

ChatGPT answer (cut and pasted):

“Living benefits on life insurance are features that allow the policyholder to access a portion of the death benefit while they are still alive, in certain circumstances. These benefits can provide financial assistance to policyholders who experience a qualifying event that impacts their health and ability to work. Here are some examples of living benefits on life insurance:

  1. Accelerated death benefit: This benefit allows the policyholder to access a portion of the death benefit if they are diagnosed with a terminal illness that is likely to result in death within a certain timeframe. The accelerated death benefit can be used to cover medical expenses or other costs associated with end-of-life care.
  2. Critical illness benefit: This benefit allows the policyholder to access a portion of the death benefit if they are diagnosed with a critical illness, such as cancer, heart attack, or stroke. The funds can be used to cover medical expenses or other costs associated with the illness.
  3. Chronic illness benefit: This benefit allows the policyholder to access a portion of the death benefit if they are diagnosed with a chronic illness that results in the inability to perform a certain number of activities of daily living, such as bathing, dressing, and eating. The funds can be used to cover long term care expenses or other costs associated with the illness.

Living benefits on life insurance can provide policyholders with greater financial flexibility and security during challenging times. It’s important to review the terms and conditions of your life insurance policy to understand what living benefits are available and how they can be accessed. Additionally, it’s important to consult with a qualified insurance professional to determine if living benefits are appropriate for your individual situation.”

Overall, I still feel very secure in my job not being replaced anytime soon, while having the ability to leverage AI instead of competing against it.

Converting A GLWB Annuity To A Roth: What Value Is Taxed?

With the hundreds of billions of dollars that are currently sitting in annuities that have guaranteed lifetime withdrawal benefits that are also IRA money, I think it’s important that I point something out that many financial professionals are unaware of. It has to do with Roth IRA conversions. It also has to do with required minimum distributions.

Let’s use an example and say that “John” rolled over $100,000 of IRA money into an annuity 10 years ago. That annuity has a GLWB benefit base that has grown to $200,000 because of the guaranteed roll ups. However, John’s annuity contract value is only $120,000. If he were to trigger the GLWB this year, he could get around $15,000 per year, just as an example. Wouldn’t it be a great concept if he could convert that IRA to a Roth IRA prior to taking that income that would later come in tax free? Before we answer that question, we should also ask the question, ”What value is it that he is taxed on when he converts the entire IRA to a Roth IRA?”

Let’s use an extreme—and slightly ridiculous—example. Extreme examples help demonstrate the point. Let’s say the benefit base has grown to $1 million. And if John were to trigger the income after that 10th year, he would get $70,000 per year, even though his contract value was only $120,000. Wouldn’t it be a fabulous idea if he can convert that entire traditional IRA into a Roth IRA and only be taxed on his $120,000 contract value, and then get $70k per year tax-free? Of course, that would be a great idea. So great that the IRS has already addressed this with a rule back in 2006 that many people are unaware of. However, as Roth IRA conversions become more prominent, I believe many folks will become more aware of this. Since you are reading this article, you will certainly be aware of the “IRS Entire Interest Rule.”

What is the answer?
So, let’s get back to the question. What value is it that determines the amount that is taxable to John in the year that he makes the Roth IRA conversion? It is neither the contract value, nor the benefit base. It is the “fair market value” of the annuity. The fair market value equals the accumulation value plus the net present value of future additional benefits (GLWB income) on that annuity. The IRS has not given carriers much guidance on the actual calculation of the net present value other than that the carrier should abide by the “reasonableness standard.” That fair market value is then put into a letter that the carrier will send your clients every year. It is usually called a “Fair Market Value Letter.” Very original, I know.

If the Roth IRA scenario sounds kind of far out and that Charlie is just doing mental gymnastics for no reason, I promise you that you will come across it eventually. Either by the Roth IRA scenario I mentioned previously or the other two scenarios below:

  1. Required Minimum Distributions: That “fair market value” which is usually larger than the contract value is also what determines the required minimum distributions on a policy that has a GLWB! Not the contract value and not the benefit base. (Note: there are a couple of exceptions to the use of the “fair market value” rule. One such example is, if the present value of the additional benefit does not exceed the contract value by 20 percent or more, then it can be disregarded.)
  2. “What the heck is this letter I received?” Eventually a client will call you up and say, “I got a fair market value statement in the mail and what does that mean?” They might be very happy because that fair market value statement will show a number larger than their current accumulation value.

The scenario in bullet point #2 is likely what you will run into the most; your clients will get these letters. At the end of last year, a client of mine called in because he got a fair market value letter stating he had a fair market value of almost $230,000. He was ecstatic because the year before he put $185,000 of IRA money into his indexed annuity. He was surprised because the stock market had been horrible, and he didn’t know how he received so much growth. I explained to him that the $230k value didn’t apply to him yet because: 1. He will not be converting it anytime soon; and, 2. He is 10 years away from his first required minimum distribution. I also told him that the present value of the GLWB benefits must have been around $45,000 ($230k minus $185k).

The last thing I mentioned to him was that the $230,000 number is nothing to get excited about, just as we should not jump for joy when the county sends us a large “assessment value” on our house. The fair market value on an annuity and the assessment value on a house are very similar and for similar purposes. Taxes.