Do you know how many of your clients own non-qualified deferred annuities?1 Does their estate planning consider how those annuities are subject to different tax and non-tax rules than other assets? These differences create both planning opportunities and traps. Because annuities are subject to both income and estate tax, a significant amount of their value can be lost at the owner's death. Fortunately, lifetime and post-mortem estate planning can minimize the impact of this double taxation.
Deferred annuities often resemble investments in bonds or mutual funds and may be purchased instead of, or in addition to them. But what clients and their advisors frequently don't consider is that deferred annuities have very different tax treatment from bonds or mutual funds, both during the clients' lifetimes and when they die. Also, a beneficiary designation, rather than estate-planning documents, normally controls who receives the annuity's value at the owner's death.
Deferred annuities involve one or more premium payments with distributions beginning more than a year after the annuity purchase. Immediate annuities call for a single premium followed by substantially equal payments beginning within one year of the annuity purchase. Deferred annuities were created to allow individuals to accumulate wealth while working. When a person stops working, the accumulated wealth can be annuitized (converted to an income stream) to provide cash during retirement. After an annuity is irrevocably annuitized, the owner is limited to receiving the income stream and generally cannot receive additional payments from the annuity. Many annuities also offer a death benefit that allows a beneficiary to receive the amount invested in the contract, less payments received by the owner. The income and estate tax treatment reflects this original purpose and design.
With the decline of defined-benefit pension plans and the doubt cast on Social Security, many individuals are attracted to the idea of receiving income streams from deferred annuities guaranteed by an issuing insurance company.2 Many annuities now offer a guaranteed income stream that does not require annuitizing the contract. As a result, many clients today invest significant amounts in deferred annuities and are likely to have significant amounts in those contracts when they pass away.
Good estate planning reflects the differences between annuities and other assets. (See “Annuty Basics,” p. 58.)
First, let's look at exactly how annuities are taxed.
Income taxation — Under Internal Revenue Code Section 72, if the owner of a deferred annuity is an individual, growth in the account's value is generally not subject to income tax until money is withdrawn. In return for this favorable tax treatment, amounts withdrawn from a deferred annuity issued (or exchanged) after Aug. 13, 1982, are taxed as coming from the growth (gain) in the contract first. The owner receives the investment in the contract (known as the cost basis) only after he's received all of the growth. In addition to income tax, growth withdrawn from a deferred annuity before the owner is 59 1/2 may be subject to a 10 percent penalty tax — unless an exception applies.3 For tax purposes, borrowing from an annuity or using one as collateral for a loan is treated as a distribution from the annuity.4
In contrast, when a deferred annuity is irrevocably annuitized, an exclusion ratio is computed to determine the amount that is taxable.5 The exclusion ratio determines the portion of each payment that represents a nontaxable return of the investment in the contract. Anything in excess of that represents taxable income. To compute the exclusion ratio, the amount invested (or cost basis) in the annuity is compared to the expected return from the annuity, using the annuitant's life expectancy (or the period certain over which annuity payments will be made.) Once the entire investment in the contract is received, all subsequent annuity payments are fully taxable.
If the owner is not an individual, the growth in the annuity will generally be subject to income tax each year, regardless of whether it's withdrawn.6 But if an entity owns the annuity as “an agent for a natural person,” there is no current tax on the annuity's growth.7 Other than some private letter rulings, no authoritative guidance exists on how to draft trusts to be agents for natural persons.8
Some general guidelines can be discerned from those rulings. First, if the trust is a grantor trust, such as a revocable living trust, the trust will generally be considered an agent for a natural person during the grantor's life. Second, irrevocable trusts must be reviewed to determine whether all of the income and remainder beneficiaries are individuals. If they are, the trust will be considered an agent for one or more natural persons. If any trust beneficiary is not an individual (a charity, for example), the trust will not be considered an agent for a natural person. A disaster clause, specifying who receives the trust assets if there are no named beneficiaries living, can prevent a trust from qualifying as an agent for a natural person. Drafters often name one or more charities as takers in default if no named beneficiaries are living. This appears sufficient to prevent the trust from qualifying as the agent for a natural person.
If a revocable trust is the owner of an annuity, specific language in the annuity is required to be able to look through the trust and allow a surviving spouse to continue the contract. Otherwise, a surviving spouse will not be able to become the owner and annuitant of the annuity and continue the contract under IRC Section 72(s). If a valid beneficiary designation exists, the annuity value will not be subject to probate, eliminating the most common reason given for naming a trust as the owner of a non-qualified annuity.
When death benefits are paid, the beneficiary will be subject to income tax on the growth in the annuity's value as income in respect of a decedent (IRD) under IRC Section 691(a). An offsetting deduction is allowed under Section 691(c) for any estate tax paid attributable to the annuity. Compounding the income tax burden is that the annuity also does not qualify for stepped-up basis.9
Estate taxation — The value of a deferred annuity is includible in the owner's estate if two requirements are met:
the owner was receiving or had the right to receive an annuity or other payments that either could not or did not end before the owner's death;10 and
the annuity contract provides that a beneficiary has the right to receive an annuity or other payment as a result of the owner's death.
The estate tax value of an annuity is based on the price of a comparable annuity issued by the same company.11 This amount may vary from the account value of the deferred annuity. If the decedent contributed only a portion of the annuity's purchase price, only a proportionate amount of the annuity's value is includible in the estate.12
Much of the planning revolves around maintaining the annuity's growth tax-deferred for as long as possible. Let's look at how that breaks down:
Identity of the annuitant — The annuitant's age is used to compute the amount of the payments made when the annuity is annuitized. Depending on the annuity, the annuitant's age may be used to determine whether certain features are available under the annuity contract. If the owner and the annuitant are the same individual, whether an annuity feature is based on the owner or the annuitant will not matter. If the owner is not an individual, certain annuity features will apply to the annuitant.
The importance of the beneficiary designation — Planners should pay careful attention to the deferred annuity's beneficiary designation. Deferred annuities normally provide that the death benefit, including the account value at the owner's death, is payable to the beneficiary named by the owner.
It is crucial to review beneficiary designations as part of any estate planning process. Assets that have beneficiary designations, such as non-qualified annuities, employer-sponsored retirement plans, individual retirement accounts (IRAs) and life insurance policies are often overlooked when estate plans are updated.
If no beneficiary was named or all of the named beneficiaries predecease the owner or disclaim all or any part of the annuity, the terms of the annuity contract will control who receives the annuity. The owner's estate-planning documents, whether a will or trust, do not override a valid beneficiary designation.
The amount payable at the owner's death will be transferred to the named beneficiary without being subject to probate if a valid beneficiary designation exists at the owner's death. Consequently, an annuity does not need to be transferred to a client's trust to avoid probate.
The beneficiary's identity also impacts the distribution options available to the beneficiary. Naming an individual as a beneficiary provides the beneficiary with distribution options that are not available to a trust, estate or other entity.
Gifts of annuity contracts — Deferred annuities can appear to be attractive assets for gifts made as part of an estate plan. They can have significant value and the potential for future appreciation. A gift of an annuity, however, can have significant income tax costs.
An individual who transfers all or a portion of an annuity for less than adequate consideration (that is to say, as a gift) is treated as receiving a taxable distribution of the deferred gain.13 The deferred gain is based on the difference between the cash surrender value of the annuity at the time of the transfer and the investment in the contract. In addition, if the donor is under 59 1/2 at the time of the transfer, the 10 percent penalty tax applies to the taxable portion of the distribution. The amount subject to tax increases the donee's basis in the annuity.14
Thus, if a mother gives an annuity with a cash surrender value of $100,000 and basis of $40,000 to her child, she will recognize $60,000 of taxable income. If she is under 59 1/2, she will also be subject to a 10 percent penalty tax of $6,000. The $60,000 gain that is recognized increases the child's basis in the annuity, making the total basis $100,000. This basis consists of the mother's $40,000 basis plus the $60,000 gain the mother recognizes due to the gift. It does not include the $6,000 penalty tax.
Lifetime planning to preserve the value of the annuity — Lifetime planning focuses on minimizing the taxes on the annuity. A life insurance policy can be purchased to provide heirs with sufficient assets to pay estate taxes on the deferred annuity. Heirs can stretch out or defer distributions from the annuity. Such planning uses the same techniques used to enable heirs to pay estate taxes on IRAs and retirement plan accounts from other assets.
If the annuity owner's health makes life insurance unavailable or unaffordable, options include using assets other than the deferred annuity or retirement assets to pay any income or estate tax and adding a rider to the deferred annuity that increases the death benefit to provide funds that can be used to pay those taxes.
This rider, sometimes called a tax-enhancement rider, provides an additional death benefit so that the beneficiaries can pay some or all of the income and/or estate taxes on the annuity and minimize the amount of the basic death benefit lost to taxes. (An additional fee will be charged for this rider.) The amount or availability of the rider can depend on the participant's age and the state of issue. (See “Tax-enhancement Rider,” this page.)
How estate taxes will be paid often depends on how these taxes are apportioned among the owner's heirs. If equitable apportionment applies, either under the tax apportionment clause in the owner's will or trust or as the default under applicable state law, the estate tax on each asset subject to estate tax is apportioned to the recipient. Thus, the annuity recipient will be charged with the share of the estate tax attributable to the annuity. If the beneficiary does not have other resources to use to pay the estate taxes, a distribution from the annuity will be needed to pay the pro rata portion of the taxes.
If taxes are apportioned to the residue or in some other manner, the deferred annuity will not bear the burden of the estate tax. This is likely to cause disputes among the heirs if the beneficiaries of the deferred annuity are different than the heirs who receive the assets used to pay the estate taxes on the deferred annuity.
Post-mortem planning — Generally, post-mortem planning opportunities concern the ability to maintain the tax-deferred status of an annuity's value in the beneficiary's hands. If the contract had been annuitized, payments from the annuity must continue at least as fast as they were being made before the owner's death. The beneficiary at this point is not relevant. Regardless of who the named beneficiary is, the annuitization option previously chosen by the deceased owner will continue at least as rapidly. Most annuities will also allow any beneficiary to take a commuted value as a lump sum.
If the contract had not been annuitized, the general rule for post-death distributions is that the amount payable at the owner's death must be paid to the beneficiary within five years of the owner's death. Deferring receipt of the account balance until the end of the five-year period not only maximizes the tax deferral, but also can result in a higher overall income tax if it causes the beneficiary to be in a higher tax bracket.
Two exceptions allow planning flexibility. First, if the annuity has not been annuitized and the designated beneficiary is an individual, the annuity value may be distributed over the life or the life expectancy of the named beneficiary depending on the terms and conditions of the annuity contract and the beneficiary's choice.15 A designated beneficiary is any individual designated as the beneficiary of the contract by the owner.16 These distributions must begin within one year of the owner's death.17
Insurance companies have varying interpretations of this provision. Some permit distribution over the beneficiary's life expectancy using the same method(s) used in determining the required minimum distributions from an inherited IRA.18 This flexibility allows the beneficiary to take additional distributions, if desired. Others require the beneficiary to irrevocably annuitize the inherited annuity over his life expectancy. Still other companies require the entire account balance to be paid out within five years of the owner's death.
The distribution rules for inherited non-qualified annuities do not allow a trust to qualify as a designated beneficiary with the ability to use a trust beneficiary's life expectancy in determining distributions. This differs from the distribution rules for inherited IRAs and retirement plan accounts.
A second exception applies if the owner's surviving spouse is the named beneficiary. Most annuities provide that a surviving spouse automatically becomes the new owner/annuitant. Others allow the surviving spouse to elect to treat the contract as her own and continue it on a tax-deferred basis.
In other words, if the contract has not been annuitized, at the death of a husband who was the owner and annuitant of a deferred annuity with his wife designated as the beneficiary, the wife becomes the owner and the annuitant, as if she were the original purchaser. She is not required to take required distributions. Any deferred gain is not recognized. She is treated as the owner for all purposes. Any distributions before she is age 59 1/2 will be subject to the 10 percent penalty tax unless an exception applies. She can name her own beneficiary.
In contrast, if the husband had named a child as the beneficiary, the child would not become the owner and annuitant. The child has two choices: (1) receive the entire interest in the contract within five years of the father's death; or (2) begin distributions from the annuity within one year of the father's death over the life of the child or a period that does not exceed the child's life expectancy.
HANDLE WITH CARE
Deferred annuities can be very useful financial products. Their unique features can make them attractive to clients, both in accumulating wealth for retirement and in managing their cash flow during retirement. These features are constantly evolving. At the same time, a deferred annuity's income and estate tax treatment differs significantly from financial products that appear at least superficially similar. This is a volatile mix requiring estate planners to give deferred annuities careful handling so clients and their heirs can realize the full benefits from the features available in deferred annuities.
- Non-qualified deferred annuity refers to a deferred annuity that is not part of an employer-sponsored retirement plan such as a 401(k) plan, 403(b) tax-sheltered annuity, Simplified Employee Pension Individual Retirement Account (SEP IRA), Savings Incentive Match Plan for Employees Individual Retirement Account (SIMPLE IRA), a traditional IRA or a Roth IRA.
- The guarantee is subject to the claims-paying ability of the insurance company that issued the annuity contract.
- Internal Revenue Code Section 72(q). Common exceptions include payments due to death, disability or as part of a series of substantially equal periodic payments made for a specified minimum duration.
- IRC Section 72(e)(4)(A).
- IRC Section 72(b).
- IRC Section 72(u).
- IRC Section 72(u)(1), flush language.
- For a discussion of the private letter rulings, see Bruce A. Tannahill, “Are Nonqualified Annuities Trust-worthy?” Probate & Property, July-August 2006, at p. 22.
- IRC Section 1014(c).
- IRC Section 2039(a).
- Treasury. Regulations Section 20.2031-8(a).
- IRC Section 2039(b).
- IRC Section 72(e)(4)(C)(i).
- IRC Section 72(e)(4)(C)(iii).
- IRC Section 72(s)(2).
- IRC Section 72(s)(4).
- IRC Section 72(s)(2).
- PLR 200313016 (March 28, 2003).
What a difference it can make
Assume the tax-enhancement rider increases the death benefit payable under the annuity by 30 percent. If the death benefit payable without the rider is $500,000, the death benefit would be increased by $150,000. The beneficiaries would receive a total of $650,000. Here's the difference with, and without, a tax enhancement rider:
|Tax-enhancement rider in a non-taxable estate|
|Without Rider||With Rider|
|Income tax (35 percent rate)||175,000||227,150|
|Net received by heirs||325,000||422,500|
|Additional amount received||97,500|
|Tax-enhancement rider in a taxable estate|
|Without Rider||With Rider|
|Estate tax (45 percent rate)||225,000||292,500|
|Income tax (35 percent rate, after deduction for estate tax paid)||96,250||125,125|
|Net received by heirs||178,750||232,375|
|Additional amount received||53,625|
|— Bruce A. Tannahill|
It pays to understand the details
The basic concept of an annuity is well-understood. But many of the details of how annuities are structured are not well understood. And insurance companies continually revise the features and terms of their annuities, so each contract should be carefully reviewed. But, quickly and generally:
Annuity contracts involve an owner, an annuitant, a beneficiary and the insurance company that issues the annuity. The annuitant must be an individual and is the measuring life for the annuity. The annuitant's age is used to determine the amount of the annuity payments, when the annuity payments must start, and whether features offered by a particular contract are available or when they can begin.
In contrast, the owner does not need to be an individual. Even if the owner is an individual, he may or may not be the annuitant. A 10 percent penalty tax1 applies to the owner, who is considered the taxpayer, because the owner controls the funds. The identity of the owner determines whether the annuity growth will be tax-deferred.
A client investing in a deferred annuity obtains the contractual right to receive a stream of payments at a future date. The annuity payments will begin when the annuitant reaches a specified age, but may begin at an earlier age.
Internal Revenue Code Section 72(s) requires that the entire interest in the annuity be distributed within certain timeframes after the owner's death in certain circumstances if an annuity has not been annuitized.2 If the annuity has been annuitized, Section 72(s) allows for acceleration of any remaining payouts but does not allow stretching them beyond the annuity option effective on the date of death.
Some annuities provide that a death benefit is paid only at the annuitant's death, even if the annuitant is not the owner. Others provide for payment upon either the death of the owner or the annuitant. The annuity may provide that the amount paid at the owner's death may be different from the amount paid at the annuitant's death. Frequently, the death benefit paid at the owner's death is simply the annuity account value, while any enhanced death benefits are payable only at the death of the annuitant. This means that if an owner who is not the annuitant dies prematurely, the annuity account value must be distributed without any enhanced death benefits. This may be a surprise to the beneficiaries, who are likely to expect to receive an enhanced death benefit.
There are different types of deferred annuities:
Fixed deferred annuities — provide that the amount invested in the annuity will grow based on interest credited to the annuity's value. Normally, the issuing company guarantees a low annual interest rate (often 1 percent or 2 percent.) A higher interest rate can be paid based on the terms of the annuity contract.
Variable deferred annuities — allow the owner to choose among investment options offered in the insurance company's separate accounts. These options often range from a fixed account offering a guaranteed return for a specified number of years to subaccounts that resemble a family of stock and bond mutual funds.
Equity indexed annuities (EIAs) — provide growth potential similar to that of stocks while protecting against potential loss in value that can result from a drop in stocks. The amount credited to an EIA is based on a percentage of the increase in a stock market index, frequently the Standard & Poor's 500. This amount is subject to a cap, usually either a percentage of the account value or a percentage of the growth in the index. A minimum crediting percentage, often 1 percent, provides a nominal return and protection from a loss in account value if the index declines.
All deferred annuities can be subject to various fees and charges designed to pay for the cost of the annuity's features, including any death benefit. Annuities frequently include a surrender charge that reduces the amount received if the owner surrenders the annuity within a certain time after it was issued.
Deferred annuities are complex financial products. They commonly offer systematic partial withdrawals guaranteed by the issuer for the annuitant's life or a certain number of years, without irrevocably annuitizing the contract. Taking withdrawals generally reduces either future withdrawals or the length of the payment period. Variable annuities often offer the ability to increase the amount used to determine the withdrawals if the value of the subaccounts grows. Death benefits can be based on the highest account value at certain times during the life of the contract. Many of these features (usually provided via riders) carry additional costs.
- Internal Revenue Code Section 72(q).
- IRC Section 72(s)(1)(B), effective for contracts issued after Jan. 18, 1985.
— Bruce A. Tannahill