Annuities and Trusts
November 5, 2017 by John L. Olsen, and Michael E. Kitces
As a financial asset, an annuity is necessarily part of the overall financial and estate plan of its purchaser.
However, it is sometimes not well coordinated with the other components. Indeed, the ownership and beneficiary arrangement of an annuity may be inconsistent with — or even in conflict with — the rest of a client’s plan.
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Not uncommonly, this results from an advisor’s decision to employ the annuity in connection with a trust without a full understanding of the rules governing both.
In the following discussion, we will examine some of the problems advisors may encounter when annuities are owned by, or made payable to, a trust, and the rules (i.e., the tax rules and the contractual provisions and administrative policies of annuity issuers) that are not well understood.
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For most of the following discussion, we will be concerned only with deferred annuities. Not only are most annuities sold of this type, but the Internal Revenue Code (IRC) provisions that cause most of the difficulties where annuities are owned by or payable to a trust (Section 72(u) and certain paragraphs of Section 72(s)) do not apply to immediate annuities. We will also be concerned only with nonqualified contracts, because of qualified annuities, or annuities used to fund IRAs, cannot be owned by a trust other than the trust for the type of retirement plan being funded.
Problematic Annuity Structuring with Trusts
Problems can arise when a deferred annuity is:
- owned by and payable to a trust;
- owned by a trust and payable to another party; or
- owned by another party and payable to a trust.
When an annuity is owned by a trust, the holder of the annuity is deemed by Section 72(s)(6)(A) to be the primary annuitant. This provision applies to any annuity owned by an entity other than a natural person, including a corporation, partnership, or trust. Primary annuitant is defined by IRC Section 72(s)(6)(B) as “the individual, the events in the life of whom are of primary importance in affecting the timing or amount of the payout under the contract.”
It is vital that the advisor understand that this provision applies with regard to distributions required to be made from the annuity upon the death of any holder by Section 72(s), if the annuity is to be considered an annuity for income tax purposes. However, what if a particular annuity does not provide for payment upon the primary annuitant’s death when the annuity is owned by a trust? The result could be a conflict — an incongruity, which might pose serious problems as will be discussed later in this chapter. This is unlikely, however, because the language in today’s deferred annuities typically requires payouts in accordance with Section 72. Moreover, most insurers that will issue a deferred annuity owned by a trust or other “non-natural person” require that entity to be the primary beneficiary.
Also, an annuity owned by a trust (or another nonnatural person) will not be considered an annuity for income tax purposes unless the owning entity is acting as the agent of a natural person. This requirement, too, is a source of potential problems. Although many trusts qualify as such agents, not all do.
When a trust is the beneficiary of an annuity, that annuity is subject to distribution requirements different from those applying when the beneficiary is an individual or a natural person. These requirements apply whether or not the trust is also the holder of the annuity.
Best Practices When an Annuity Is Being Used in Connection with a Trust
Many advisors rely upon the marketing materials, home office marketing representatives, or external wholesalers of insurance companies for their understanding of those companies’ insurance products. To be sure, these sources can be very helpful. But they may not be sufficient.
Sometimes, they are either unclear or just plain wrong.
Most experienced advisors have at least a few horror stories of home office marketing representatives or wholesalers who made statements about the operation or tax treatment of an insurance product that was totally inaccurate. The authors have more than a few of these stories as well. Those of us who are not licensed attorneys cannot, and should not, practice law. But we can, should, and must exercise due care in our advisory activities. Therefore, with regard to annuities, the authors strongly recommend that advisors consider the following caveats:
- Avoid naming a trust as annuity owner unless there is very good reason for doing so and you are sure of all of the results of structuring the contract ownership this way — including when (i.e., due to which deaths) the insurance company will pay a death benefit and under what conditions any death benefit enhancements will be payable.
- Avoid naming a trust as beneficiary, for the same reasons, unless there is truly no need or desire to stretch the payments of the annuity after death and a post-death liquidation of the annuity under the five-year rule will not cause a tax hardship.
- Avoid naming different individuals as owner and annuitant, for the same reasons (and in the case of a trust, be cautious if the grantor and annuitant are different persons). This is a good rule to observe, whether a trust is involved or not. The potential problems resulting from different individuals named as the annuitant and owner are so common and serious that some insurance companies refuse to issue contracts on this basis.
- If the owner and annuitant will be two different individuals, know whether the contract you are considering is annuitant-driven or not.
The above list is not a complete recitation of things to know and avoid about annuities, but merely the authors’ suggestions of the most vital caveats to consider when annuities and trusts are both involved. A better general caveat might be this:
