Taxation of Annuities

Annuities and Trusts


A particularly troubling set of tax problems can arise when an annuity is owned by a trust, or a trust is named as beneficiary of an annuity.  A trust is not a natural person -- therefore it cannot die.  This means that all trust-owned annuities must rely on a separate annuitant as the measuring life (i.e., the owner and the annuitant are necessarily different).  Put another way, all trust owned annuities must also be annuitant-driven annuities.  As we just learned, annuitant-driven contracts are more likely to lead to unintended consequences than owner-driven contracts.  


Often a financial advisor will recommend that all of a client's assets should be placed within a revocable living trust for estate planning purposes.  But this recommendation is usually made without a full understanding of the tax rules governing annuities and trusts.  Moreover, placing an annuity within a trust may conflict with the rest of the client's estate plan.  In most cases, there is little benefit to owning an annuity within a trust.   Trusts are usually set up to avoid probate; but an annuity's death benefit automatically passes "by contract" to the beneficiary, so it will pass outside probate anyway.  Sometimes trusts are employed to provide more flexible distribution of the proceeds than simply naming an individual; but the trust could be named as beneficiary without being also named the owner.  Or perhaps there is a fear that the owner may become incompetent, Alzheimer’s for instance; but a durable power of attorney would address that fear.  In light of the problems that can arise from trust-owned annuities and the availability of reasonable alternatives, it rarely makes sense for a trust to own an annuity.  


As was noted earlier, annuities owned by a trust that simply represent a “natural person” will enjoy tax-deferred growth in the contract.  If the trust has another purpose, however, the trust loses that tax-deferred status.  In those cases, the trust will have to pay income tax annually on the earnings that accumulate in the contract.


If a trust is named as a beneficiary, there is a different set of possible adverse outcomes.  Since a trust cannot be a "designated beneficiary", if death benefits are payable during the accumulation phase, they must be taken under the general five-year payout rule.  The annuitization or spousal continuation exemptions apply only to designated beneficiaries (i.e., individuals, not trusts).   There are some situations when naming a trust as beneficiary may provide greater flexibility in distributing the contract's death benefits.  If the need for flexibility outweighs the less-favorable distribution rules, naming a trust as beneficiary may make sense. Financial advisors should be very careful when recommending that a trust be named as beneficiary. They should fully understand the tax code on this issue, the wording of the contract, and the administrative policies of the annuity company.


To summarize some of these pitfalls, advisors should:


¨ avoid naming a trust as the owner of the annuity unless there are clear reasons for doing so and understand all of the ramifications of that designation

¨ avoid naming a trust as beneficiary of an annuity unless there are clear reasons for doing so and understand all of the ramifications of that designation,

¨ avoid co-ownership of an annuity,

¨ avoid naming different individuals as owner and annuitant, and

¨ if the owner and annuitant are different individuals, confirm whether the contract is annuitant-driven or not.



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