“Your annuity meets your trust … OOPS”
March 2, 2016 by John Olsen
If you have clients who are like many Americans who’ve accumulated enough wealth to be concerned about how it will pass to their heirs, they have established one or more trusts. And if they’re like almost every American, they’re concerned about having enough income in retirement. Perhaps they’ve bought some type of commercial annuity contract to provide that income. Both trusts and annuities can make a lot of sense, but when they’re put together, unexpected and unpleasant things can happen.
Annuity contracts and trusts can interact in two ways. The trust can be the owner of the annuity and/or be its beneficiary. Each can result in problems if the payout conditions and taxation of distributions from the annuity are not fully understood (and desired).
Example #1: George had a deferred annuity (one in which regular annuity income need not be begun in the first year) and had named his wife, Gracie, as beneficiary. Under that arrangement at George’s death, Gracie had four choices with regard to the money in the annuity:
- 1. She could take the entire value of the annuity in a lump sum
- 2. She could wait up to five years to take that money and not have to pay tax on the as-yet-untaxed “gain” in the contract until she took it out.
- 3. She could take the proceeds as a regular annuity income over any period not extending beyond her life expectancy.
- 4. She could treat the annuity as her own, as if she’d bought it originally.
However, George’s advisor told him the annuity ought to be made payable to George’s revocable living trust, and George executed that change. Later, he died. The annuity had done very well over the year, and, at George’s death, was worth more than double the $100,000 he’d originally contributed. At that point, Gracie didn’t need the money in that annuity (having received a lot of life insurance money) and asked the insurance company what her options were.
She didn’t like the answer.
They told her she had to take distribution of the entire proceeds and pay ordinary income tax on the more than $100,000 of “gain” within five years. She could no longer take it as an income for life or treat the contract as her own.
Example #2: Betty, an elderly widow, established a trust for the benefit of her younger sister’s retirement. The trust bought a deferred annuity to obtain tax-deferral of the annual annuity interest earnings and the sister was named annuitant. Later on, when the sister needed funds, she learned that all distributions from the annuity would be taxed at 110 percent of the ordinary income tax rate until all the annuity interest had been distributed.
Things like this do not have to happen. They can be avoided when the planners fully understand how annuity contracts are taxed especially when a trust is involved.
If you’re considering purchase of a deferred annuity where a trust will either be the owner or beneficiary, get competent tax advice before doing anything.
