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Before You Let Your Deferred Annuity Be Owned By or Payable to a Trust…Read This

John L. Olsen

If you own, or are considering buying, a deferred annuity and are thinking of having a trust own or be the beneficiary of that annuity, you need to be aware of the tax consequences. In this article, we’ll examine those consequences. But before we start, we need to be clear on two things: First, the author is not an attorney and is not giving you tax or legal advice. You should consult your legal advisor for that. Second, the tax treatment describe here applies only to deferred annuities (contracts that have an accumulation period, during which your money earns interest; immediate annuities, which provide an income beginning within one year of purchase, get very different tax treatment and do not present the issues described here. When the term “annuity” is used here, it means specifically “deferred annuity”. With those understandings, let’s get going.

When a Deferred Annuity is Owned by a Trust

When a deferred annuity is owned by a trust, several special tax provisions apply. The first concerns tax deferral.

Trust-Owned annuities and Tax Deferral

The annual growth inside a deferred annuity is generally not taxable until it is withdrawn. Thus, the tax on this gain is deferred until such withdrawal. We said “generally not taxable” because this is not always true. If a “non-natural person” (a corporation, partnership, or other entity that is not a human being) owns a deferred annuity, the annual growth is taxable as earned unless that entity is acting as “the agent of a natural person” (IRC [Internal Revenue Code] Section 72(u)). The IRS has held, in numerous Private Letter Rulings, that a trust can qualify as such, so long as all the beneficiaries are human beings. But you should not assume that your trust will qualify. Consult your legal or tax advisor on this point.

When a Trust is the Owner, Whose Death Triggers the Death Benefit?

Deferred annuities cannot continue in force forever. In the Tax Reform Act of 1986, Congress created a rule (IRC Section 72(s)) stating that they must pay out in full, either in a lump sum or a series of payments, when the owner dies. But corporations, trusts, and other “non-natural persons” don’t die as human beings do, so Congress created IRC Section 72(s)(6)(A), which states that when a deferred annuity is owned by a non-natural person, the primary annuitant will be deemed to be the owner.

So, when a trust owns a deferred annuity, it must be paid out upon the death of the primary annuitant. But it’s not quite that simple. Suppose George establishes an irrevocable “grantor trust” for the benefit of his daughter, Sally. (A grantor trust is taxed differently from other trusts; all income is taxed, not to the trust, but to the person who created the trust – the “grantor” – and an irrevocable trust cannot generally be changed or undone by the grantor. Because of this, the trust is generally not includible in the grantor’s estate for estate tax purposes). Now, suppose that Sally, as trustee of the trust, buys a deferred annuity, naming herself as annuitant. You’d think that the annuity must be paid out at Sally’s death, because she’s the annuitant. And so would many insurance companies, but not all of them. Some insurers apply the “grantor trust” rules in this situation and require the annuity to pay out at George’s death. What does this mean for you, the consumer? It means that if you’re thinking of doing something like this, find out how the insurance company you’re considering will handle this. You need to know when that annuity must pay out.

When the Owner Dies, What Are the Beneficiary’s Options?

But an even more important, and much more common, question is: When a deferred annuity must pay out, how must it pay out? Here are the rules when an owner of a deferred annuity dies before annuity payments have begun. If the beneficiary is a human being, he/she has four choices (Under IRC Section 72(s)).

  1. To take the annuity value as a lump sum.
  2. To take the annuity value within five years of death.
  3. To take the annuity value in regular annuity payments for life or a shorter period.
  4. If the beneficiary is the surviving spouse of the owner, to treat the annuity as his/her own. Under this option, the survivor beneficiary may keep the contract in force, just as if he/she had been the original buyer.

But what if the beneficiary of that annuity is a trust? The last two options are generally not available. Most insurance companies will require the annuity to be fully paid out over no longer than five years.

So, is this a problem? Well, suppose the annuity is worth $1 million at death, but its “cost basis” (basically, the amount the purchaser paid) is only $500,000. If the beneficiary is a trust, that half million dollars of profit (the annuity value minus the cost basis) must be included in the beneficiary’s taxable income within five years. But if the beneficiary were a human being, that tax on the profit could be “stretched out” over the beneficiary’s lifetime. And if the beneficiary were the owner’s spouse, he/she could keep from paying tax on that gain for as long as desired. Eventually, the profit will be taxed to that spouse, or his/her heirs, because “tax deferred” means what it says, not “tax free”.

Would you rather stretch that income tax liability over your entire lifetime or pay it all over five years?

The purpose of this article is not to offer tax or legal advice, and I’ve simplified the issues considerably.  But I hope that this very general discussion will give you an idea of the problems that can arise when you name a trust as owner or beneficiary of a deferred annuity.

BE SURE TO CONSULT YOUR TAX OR LEGAL ADVISOR!

For more information, see Taxation and Suitability of Annuities, by John L. Olsen, CLU, ChFC, AEP (Olsen & Marrion LLC, 2012 – www.indexannuitybook.com).

Click here for more articles from this author.

About the Author:

John L. Olsen, CLU, ChFC, AEP is an insurance agent and estate planner practicing in St. Louis County, Missouri. With over 40 years of experience in the financial services industry, he serves on the boards of the St. Louis Estate Planning Council and the St. Louis chapter of the Society of Financial Service Professionals and is a Past President of the St. Louis chapter of NAIFA.  If this article was helpful to you, be sure to check out the books listed on one of John’s websites: www.indexannuitybook.com.

In addition to serving his own clients, John provides case consulting services to attorneys, accountants, insurance agents, and financial advisors, and provides expert witness services in litigation involving annuities and investment products. Contact John at (314) 909-8818 or jolsen02@earthlink.net to receive personalized professional guidance in addressing your retirement needs.

 

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2 Comments

  • Thomas mclaren says:

    Thank you for this article.
    I am not clear on one point. If the beneficiary chooses to stretch out the payments over their lifetime and they essentially annuitizing the deferred annuity? What would happen if they were to die a year later for example.
    Thank you for you input.

  • Bobbie Berger says:

    My client is in her nineties, great health and wealthy. The deferred annuities will allow an owner up to age 90 with a Third Party signature. So I’m listing her revocable trust as “owner” and she as “primary beneficiary”, with no age limits. Do you see any problem with this? She is the trustee of her trust.

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