ANNUITIES and ESTATE PLANNING

By Nathaniel E. Clement, J.D.

This article discusses deferred annuities and estate planning. If you have a revocable living trust the question is "Who should own the annuity and who should be the beneficiary?"  I address that question in this memo.   (NOTE that annuities owned in 403(b) plans or IRAs are beyond the scope of this memo. The term "you" in this memo refers to the owner of the annuity.)

First, let us say that we like annuities as investments.  Annuities have many advantages over traditional mutual funds.  If you would like to know why annuities are usually better than traditional mutual fund investments, call or email us for a reprint of an article by attorney John Huggard which deals with this subject.

Now, some of the basics about annuities:  Annuities are investment vehicles specifically sanctioned by the Internal Revenue Code (the "Code").  The Code grants tax advantages to this type of investment.  An annuity is a contract between an owner (you or a trust) and an insurance company (the issuer) that outlines certain promises the issuer makes to you.

From a legal standpoint, there are three elements to an annuity contract:

(1) "OWNER." The "owner" is the person (or trust) who possesses rights commonly associated with owning anything of value.  the Owner has the right to take money out of the annuity or even liquidate the annuity, the right designate a death beneficiary of the annuity, and the right to "nnuitize^"(1)  the annuity. A living trust may be named as the owner of the annuity. Ownership is discussed in more detail below.

(2) "ANNUITANT." The "annuitant" is the "measuring life" for the annuity.  The reason a measuring life is needed is that an annuity can, if the owner desires, be "annuitized" at any point..⁽¹⁾ Almost always the annuitant will be one and the same as the owner, but there is no requirement that the annuitant and owner be the same. Seldom can the annuitant be changed once the annuity contract is purchased. Note: Do not attempt to name a living trust as the annuitant. Even if you were allowed to do so, it is likely this will be viewed as a "transfer" of an annuity, which is a taxable event.

(3) "BENEFICIARY." The term "beneficiary" refers to the person, or trust, or charity, who will inherit the annuity when the annuitant dies - many contracts refer to the trigger event as a "distribution event."⁽²⁾  Annuity contracts always guarantee a minimum value for the annuity contract when the annuitant (or owner) dies.  (If the annuity contract has been "annuitized" this is not the case.)  The beneficiary of an annuity inherits the annuity contract and is given certain rights under the contract.   Beneficiary designations are discussed further below.

Ownership. If you have a living trust, the owner of the annuity could be either your living trust or you personally; it is a matter of personal preference.  Sometimes when you change the owner to your living trust, the insurance company will treat this (mistakenly) as a taxable event and send a 1099 to the owner.  When this happens you have to contact the insurance company and tell them a mistake has been made.⁽³⁾

One advantage to naming your living trust as the owner is disability planning.  Naming your living trust as the owner means that if you are incapacitated, the Trustee of your living trust can access the cash value of the annuity and use that for your support during the period of incapacity.

In order to name your living trust as the owner, you must do this: (1) Verify that you are also the annuitant; (2) Verify that the death of the annuitant is the event that triggers a distribution to the beneficiary of the annuity; (3) Call the annuity company and ask them "if I change my annuity to my living trust is the insurance company going to send me a 1099?" If you get a "yes" to questions 1 and 2 and a "no" to question 3, you may change ownership of your annuity to your living trust.

If you don't get satisfactory answers to the above, then leave the ownership of the annuity where it is. Assuming your estate planning documents contain a properly prepared Power of Attorney, the agent named in the PoA can probably gain access to the cash value for your benefit in the event of an incapacity.

 Under the annuity rules in Section 72(u) of the Internal Revenue Code, in order to obtain tax-deferred treatment on an annuity, a "natural person" has to be the owner.⁽⁴⁾ You definitely want to have "natural person" status for an annuity - because that's what allows you to enjoy tax-deferred build-up inside the annuity. What is a "natural person?" It's clear that a natural person is a living, breathing human being. But it's more than that. Section 72(u)(1) of the Code allows also for some type of trusts or other entities to hold an annuity as "agent" for a natural person. The IRS has issued no official regulations on what is an agent, but it is clear in unofficial pronouncements that a revocable living trust does qualify as an agent for its maker.  Additionally, some types of irrevocable trusts can be "natural persons."

Beneficiary. Who the beneficiary of an annuity should be depends on your goals. If a person has an living trust estate plan containing "optimum tax planning" provisions⁽⁵⁾ AND if the owner of the annuity needs the assets of the annuity in order to fully fund his or her Family Trust, you face a dilemma. To get funds in the annuity contract into the Family Trust, you risk terminating the tax-deferral of the annuity, unless the Family Trust, somehow, can be considered an agent for a natural person. The private letter rulings on the "natural person" question indicate that for an agency relationship to be present, a trust must hold the annuity on behalf of a single natural person. Also, the Trustee of the trust must have the discretion to distribute income and/or principal to the beneficiary, and, upon termination of the trust, the Trustee of the trust must distribute the annuity contract to the beneficiary. In other words, the beneficiary of the trust has to be a stand-in for the real owner of the annuity.

The typical Family Trust, in the opinion of this writer, does not qualify as an agent for the surviving spouse. This is because the typical Family Trusts benefits more than one beneficiary - the spouse and the children are often "sprinkle" beneficiaries. Assuming this could be drafted around (by naming the spouse as the only beneficiary of the Family Trust), there is a bigger problem: Family Trusts are drafted to prevent the assets of the Family Trust from being includible in the estate of the surviving spouse. Rulings of the IRS indicate that for a Family Trust to be agent of the surviving spouse, the Family Trust must, when the spouse dies, be distributed to the estate of the surviving spouse. This is certainly not the purpose of the Family Trust!  Nevertheless, this writer has seen some professional insurance advisers advise that it is proper planning for a traditional Family Trust to own an annuity contract.

From a tax-planning perspective, if the maker of a living trust knows that he (she) has insufficient assets to fund his Family Trust at his death, he has to make a choice: He can name his spouse as beneficiary, which will allow her to continue the annuity after his death as a tax-deferred vehicle. Alternatively, he can name his Family Trust as the beneficiary, which will cause, at his death, the Family Trust to have to pay income tax on the inside build-up in the annuity. The choice is not always easy and has to be decided on a case by case basis. If tax planning is not a factor (perhaps there are sufficient other assets to fund the Family Trust at the maker's death), then name the spouse as the beneficiary. A wait and see strategy is also available, and is often the strategy I recommend.  "Wait and See" works this way:  Name the spouse as the primary beneficiary and the owner's living trust as the contingent beneficiary.⁽⁶⁾ This strategy will allow the surviving spouse to evaluate the tax situation at the time of the owner's death and decide whether she should take the annuity or whether she should disclaim and allow the annuity to flow to the living trust and then be allocated to the Family Trust.⁽⁵⁾ NOTE: In order to achieve the above planning result, the annuitant must be the person who is doing the planning, not some other person and the death of the annuitant must trigger the distribution event. If you are not sure about this, you must check the annuity contract.

What if My Annuity is a "Joint Annuity?" A joint annuity refers to one that has either two owners or two annuitants, or both of these. For estate planning purposes, joint annuities should be assumed to be "wild cards." By this I mean that it is difficult to know where the funds in the annuity will "flow" when a party to the contract dies. A close reading of the particular annuity contract is required and often the contract is vague or just plain confusing.  Joint annuity contracts must be examined closely!  If the joint annuity has two owners, it is generally best to attempt to change ownership to the name of only one person; in the event the contract names joint annuitants, the insurance company usually (but not always) prohibits a change.

How Should Changes to Ownership and the Beneficiary be Made? The best method for changing the "owner" or the "beneficiary" of an annuity is to work through the agent or financial advisor who sold the annuity. Another way is for you to contact the company directly and ask for their assistance. A third way, but not the optimal, is for you to complete a generic "Change of Beneficiary" form. Always get confirmation from the company that the change of ownership or beneficiary has been recorded.

Revised January, 2004

======================

FOOTNOTES:

1. To annuitize an annuity means to convert the lump sum of money in the annuity contract to a fixed payment stream to the annuitant for the rest of his or her life.  The insurance company's credit stands behind the payment stream.

2. However, annuity contracts issued pre-1986 probably define a distribution event by the death of the annuitant (only).  Prior to 1986, income earned inside an annuity was deferred no matter who owned the annuity, whether the owner was a natural person or not. The Tax Reform Act of 1986 enacted measures to prevent corporations and other entities from using annuities as tax-deferred accumulation devices. Ultimately, the contract has to be examined closely to determine what triggers a distribution to the beneficiary. 

3. Here is the reason for the above question about the "1099:" Anytime you get a 1099, it means you have to pay income tax! You don't want to have to pay income tax on your annuity! Many agents and, in fact, some insurance company personnel, don't know that it's permissible for a revocable living trust to own an annuity. It's when they believe it's not permissible that you're likely to get a 1099. That's why you should ask the company before you give them instructions to change the ownership of your annuity. Under the annuity rules in Section 72(u) of the Internal Revenue Code, in order to get tax-deferred treatment on an annuity, a "natural person" has to be the owner.

4. IF YOUR ANNUITY WAS ISSUED PRIOR TO FEBRUARY 28, 1986, your annuity is grandfathered from the natural person rule. In this case you should seek advice from a competent professional before changing ownership or before making additional contributions to the annuity.

5. Tax planning with a living trust means the trust contains provisions for establishing a "Family Trust"  at the death of the first spouse to die. NOTE: This trust established at death of the maker/grantor of the living trust is sometimes called the "credit shelter" trust and sometimes the "B" trust.

6. Joseph P. Smith has a living trust dated Sept. 1, 20xx. The contingent beneficiary of his annuity would be "The Joseph P. Smith Family Trust Dtd Sept. 1, 20xx."