Investors & Objectives



Annuities held within a trust, or annuity distributions paid into a trust, can be problematic.  Advisors should be aware of the adverse consequences when mixing annuities and trusts.  The tax consequences of purchasing an annuity in a trust account were discussed in great detail in Chapter 2.  Advisors should resist the urge to put annuities within a trust out of the simple belief that "everything should be held in the trust" to aid estate management and disposition.


Often, a contractholder will want to name his or her trust as the beneficiary of the annuity.  In these cases, the annuity must be distributed under the "five-year rule" discussed in Chapter 2.  By contrast, an annuity payable directly to a beneficiary (outside of a trust arrangement) can be paid out over the beneficiary's lifetime which provides additional tax-deferral under the "stretch annuity" principle noted above.   Presumably, distributions payable to a trust serve some other estate planning goal such as estate liquidity or greater control over the ultimate distribution to beneficiaries.  In the absence of other valid planning reasons, the investor's estate plan may be better served by designating the ultimate beneficiary, rather than a trust, to receive the annuity proceeds. 


Problems also arise when annuities are owned by a trust.  In these cases, the owner of the trust cannot be the "measuring life" as the trust itself has an indefinite lifespan.  This means that all trust-owned annuities must be "annuitant-driven" (a measuring life other than the owner's dictates when annuity payments begin).  There are important distinctions between "annuitant-driven" and "owner-driven" annuities -- and annuitant-driven annuities are more susceptible to unintended consequences and adverse tax treatment. 


Remember that trusts that simply act as an agent of a “natural person” enjoy tax-deferred growth.  Most living trusts fit that description.   If, however, a trust has other purposes, it is not eligible for tax deferral of earnings.  These trusts must pay tax annually on the earnings within an annuity contract. 


The tax treatment of annuities and trusts was discussed in detail in Chapter 2.





Charitable organizations represent a large market for annuities.  One common estate and tax planning tool is the charitable remainder trust (CRT). CRTs are irrevocable trusts that provide for and maintain two sets of beneficiaries. The first set is the income beneficiaries (the investor who funds the trust and, if married, a spouse).   Income beneficiaries receive a set percentage of income for their lifetime from the trust. The second set of beneficiaries is the charity(s) named by the grantor. The charity receives the principal of the trust after the income beneficiaries pass away.  Because of the two types of beneficiaries, CRTs are a type of "split interest" trust.


While a CRT is an irrevocable trust, the grantor (and spouse or other person) may change the charitable beneficiaries during their lifetimes. Under certain conditions, the grantor may even serve as trustee of the CRT and maintain control of the investments inside the CRT.   More often, however, the charity employs a trustee this offers the grantor a "turnkey" mechanism to turn over that responsibility to someone else.


Congress' intention when it allowed CRTs was to enhance donations to charitable organizations.  As a charitable donation, CRTs offer some powerful tax-saving advantages.  The most obvious is a charitable deduction on the donor's  tax return.  The size of the deduction depends on the present value of the amount the charity can expect to receive -- which, in turn, is related to the current fair market value of the asset, the size of the income payout percentage selected by the grantor, the expected length of the payout period, discounted by an IRS-approved interest rate.  There are limitations on the size of the income tax deduction that can be taken each year (based on factors such as the grantor's taxable income and the type of asset donated.)    These limitations apply to income tax deductions only.  The full value of the charitable donation will be deductible for gift and estate tax purposes. 


Because the assets in the trust are destined for a charity, Charitable Remainder Trusts do not pay any capital gains taxes. For this reason, CRTs are ideal for assets like stocks or property with a low cost basis but highly appreciated value. For instance, suppose a charitably–inclined investor sells an apartment building for $1 million, with the intention of donating the proceeds to a charity. Let's assume she originally paid $100,000 for the property. Upon completion of the sale, she would owe capital gains taxes on the $900,000 difference. That tax could easily top $150,000, depending on how long she owned the property and her overall tax situation.  If instead, she funded a CRT with her apartment building, she effectively sells that assets without paying any capital gains taxes. Since CRTs have a charitable intent and do not have to pay capital gains taxes.  As a result, the full, pre-tax value of any assets is transferred to the trust (which will provide a lifetime income to the grantor and the trust’s principal ultimately goes to the named charity).


The amount of income to come out of the CRT depends upon the payout percentage the grantor chooses, and the amount of income the assets generate while inside the CRT. The IRS states that, at a very minimum, the CRT must distribute at least 5% of the net fair market value of its assets. The payout percentage chosen by the grantor will affect the size of a charitable income tax deduction the grantor may take: the higher the payout percentage, the less available to the charity — and therefore a lower charitable tax deduction.  Another consideration: setting too high of a payout percentage may reduce the principal inside the trust quickly. Payouts in excess of 10% each year can be problematic. 


For clients concerned with leaving assets to their children, a portion of the income payments can be used to purchase a life insurance policy, payable to the children or others, to replace the value of the assets placed in the CRT this is typically done through a separate "wealth replacement trust".  


CRTs come in two flavors: "charitable remainder annuity trust" (CRAT) and "charitable remainder unitrust" (CRUT).  The distinction is how the payout percentage is applied each year to determine the amount of the income payment for the grantor.  Charitable remainder annuity trusts are set up to provide a fixed amount each year.  Using the above example, the grantor transfers a $1 million investment into a CRAT with a 5% annual payout.  The CRAT will pay 5% of the initial contribution, or $50,000 per year to the grantor.  In the case of a charitable remainder unitrust, the grantor will be paid 5% based on the current value of the trust.  The first annual payment will be $50,000, and future payments will be based on the value of the trust, recalculated each year.  Suppose in year 2 the trust's value has increased to $1,100,000 -- the second annual payment will be $55,000 (5% of $1,100,000).   Since CRATs pay out a fixed dollar amount each year, fixed annuities are an ideal funding mechanism.  For those wanting to participate in future growth, the CRUT is more appropriate and variable annuities can be an appropriate vehicle to deliver those varying income payments.   [Some CRUTs include a makeup provision to essentially hold "excess" income for future distribution, these are sometimes called NIMCRUTs (Net Income with Makeup CRUTs) and these can be designed with a "spigot" feature to allow the grantor to turn on or off distribution of the excess.]    There are a couple of other differences between the two types of CRTs.  CRATs do not permit additional contributions to the trust, CRUTs do allow for additions to the trust corpus.  CRUTs must incur the cost of an annual reevaluation of the trust assets; CRATs do not. 


Needless to say, setting up a CRT (of either type) is a complex transaction governed by many detailed tax regulations.  For clients who would like to convert a highly-appreciated, illiquid or low-yielding assets into a stream of income, CRTs may be an appropriate solution.   CRTs may also help the grantor to diversify his or her holdings.   Advisors should be very careful when setting up CRTs to use experienced and knowledgeable experts to draft the proper documents and obtain tax advice.  CRTs are also subject to extensive accounting requirements.  As noted earlier, many charities have financial departments to assist in the process of setting up and managing CRTs.


 A very informative website for those interested in more information on CRTs can be found at





Corporations (or other business entities) may find annuities to be helpful in meeting their obligations.  The most common corporate use of annuities is to fund and distribute pension payments to their retirees.  This was the initial reason issuers developed group annuities.  Prior to the development of modern group annuities in the early 20th century, pension plans were a pay-as-you-go pension scheme, which primarily benefited corporate executives.  Corporations would simply pay benefits to retired executives out of current earnings.  Group annuities allowed corporations, in exchange for premium payments, to shift that responsibility as well as the investment and mortality risk to insurance companies.  This also allowed for the expansion of retirement benefits to more rank-and-file employees either paid fully by the employer, or through employee contributions. These group annuities provided a fixed retirement benefit usually based on the number of years of service.



Qualified Plans


When federal pension laws were reorganized under the Employee Retirement Income Security Act (ERISA) in 1974, traditional pension plans, were reclassified as defined benefit plans.  As the label suggests, the benefit is "defined" (i.e., fixed by some sort of formula).   ERISA mandates that defined benefit plans purchase insurance coverage from the Pension Benefit Guaranty Board (the cost of which has increased over the years).  ERISA also imposed greater accounting and funding requirements on defined benefit plans to assure that companies would have adequate funds available to meet its obligations. Plans that purchase an annuity to guarantee funding are exempted from many of the additional costs of these new regulations.  As a result, ERISA motivated many defined benefit plans to become "annuity purchase plans", creating a large market for group annuities.  In these traditional annuity purchase plans, the group annuity serves as a vehicle to accumulate pension funds during the employee's working years, and eventually as a distribution vehicle to pay the defined benefits.   


As life expectancies lengthened, the legacy costs promised to retirees increased.  In the last decades of the 20th century, many companies shifted from defined benefit plans to defined contribution plans.  Instead of guaranteeing a fixed benefit to retirees, companies chose to guarantee a fixed contribution to the pension fund.  The fund would eventually pay retirement benefits based on employer and employee contributions, plus investment income generated by the plan's portfolio.  Initially, such plans were "money purchase" plans.  Money purchase plans essentially hold a portfolio of investments for benefit of the employees as a group and are managed by the corporation as a trustee.  Over time, individually tailored plans such as 401(k) plans became more popular monies are be deposited into an employee's individual account and the employee directs the fund's investments.  (Tax Sheltered Annuities, discussed above, serve the same role for non-profit employers.)  Regardless of the size and type of the account, all defined contribution plans shift the investment risk from the employer to the employee.  Annuities, especially variable annuities with their separate accounts, are commonly used to meet the accumulation needs of the defined contribution plan.  Even in those cases where the corporate trustee directly manages the investments in the plan, annuities may be an ideal vehicle for distribution of benefits to retired employees.     Companies with defined benefit plans can use a portion of the investment fund to purchase an individual annuity to pay benefits for each retiree, or the company may opt for a group annuity to cover all of the company's retirees.  The retirement benefits can be paid out as a guaranteed fixed annuity (subject to inflation risk), or based on the investment results of a variable annuity's separate account (subject to investment risk). 


A 1982 amendment to ERISA mandates that retirement benefits paid to married workers must be paid in the form of a joint annuity, unless the worker's spouse waives that requirement in writing.  This requirement, designed to protect widows and widowers from having their income cut due to the death of the covered worker, encourages the use of commercial annuities as a distribution vehicle for retirement benefits.    


Separate accounts holding the investment portfolios of a variable annuity are typically registered with the SEC under the Investment Company Act.  Some group variable annuity contracts are exempt from that registration requirement.   Group variable annuities that are sold exclusively to qualified retirement plans need not register.  This exemption applies only to plans covering at least 25 employees in which the employees make no contribution to the purchase of the annuity.  Variable group annuity contracts may be issued under other conditions, but they must be registered under the Investment Company Act.



Non-Qualified Plans


While qualified retirement plans represent a large market for annuities, corporations can also use annuities to fund non-qualified retirement programs, such a deferred compensation plans.  Non-qualified plans do not need to meet the broad participation standards of ERISA and can be targeted to a select group of “key” employees, instead.   Non-qualified plans can be an inducement when hiring new personnel, or they can be used as “golden handcuffs” to retain employees who are critical to the company’s success.  In a non-qualified deferred compensation plan, the employee will forgo some of his or her current, taxable compensation in return for a promise of greater retirement benefits.  The idea is to defer paying taxes on today’s income and receive it in the future, presumably when the retiree is in a lower tax bracket.    The employer can use the deferred compensation to purchase an annuity contract to fund and pay the promised retirement benefits.  



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