Planning in Deferred Annuities

One of the greates challenges facing those of us who sell or give advice about deferred annuities is the complexity (and in some cases, inscrutability) of the tax laws governing these contracts. Many of the tax mines that can cripple or kill a client's financial plan are triggered by seemingly appropriate ownership or beneficiary choices made through a misunderstanding of the implications of those choices.

Parties to the Annuity Contract

There are four parties to a deferred annuity contract - the issuer, the owner, the annuitant and the beneficiary. The issuer is always the insurance company from whom the annuity is purchased. But the other three parties may be chosen by the purchaser, and those choices are important, as they determine when, how and to whom distributions from the annuity must be made and how they will be taxed.

The owner is the person or entity (it need not be a human being) who owns all the rights in the annuity contract and who bears the tax liability for all distributions from it, actual or imputed, other than death proceeds paid to beneficiary.

The annuitant is the "measuring life": the person (it must be a human being) whose age, sex (in non-unisex contracts) and state of health (in medically underwritten annuities) will determine the amount of each annuity payment. Contrary to popular belief, the annuitant is not necessarily the individual who will receive annuity payments. The owner makes that decision.

The beneficiary is the party (human or otherwise) who is entitled to receive the proceeds of the annuity up on death. But whose death? It depends on (a) whether the contract is annuitant-driven and, if it is, on (b) the identity of the decedent.

Whose Death Triggers Which Death Benefit?

With regard to required post-death distributions, there are two kinds of annuity contracts. An annuitant-driven contract pays the guaranteed death benefit to the beneficiary up on the death of the annuitant. An owner-driven contract pays that benefit on the death of the owner. Obviously, this distinction is moot if the owner and annuitant are the same individual (as they should be, unless there's a very good reason for doing it otherwise). But what if the owner and annuitant are not the same person? That's where it gets tricky.

All deferred-annuity contracts issued since Jan. 18, 1985, will pay out the contract cash value upon the death of the owner - because Internal Revenue Code (IRC) Sec. 72(s) requires it - so we might say that all such contracts are owner-driven. But some are also annuitant-driven, because they pay the guaranteed death benefit upon the death of the annuitant. If the annuitant and the owner of an annuitant-driven contract are different parties, and if that contract provides for a guaranteed minimum death benefit that may exceed the cash value, there may bwe two death benefits, payable upon different events. The annuitant's death will trigger the guaranteed death benefit, and the owner's death will trigger payment of the cash value. This can lead to confusion and complaints. The problem can be avoided, either by using an annuity that is not annuitant-driven or, better yet, by naming the same individual as both owner and annuitant.

When the Deferred Annuity Is Owned By a "Non-Natural Person"

If a deferred annuity is owned by a non-natural person (e.g., a trust, partnership or corporation), it will not be treated as an annuity contract for tax purposes, which means that annual earnings will be taxable as earned, as per IRC Sec. 72(u). This treatment will apply unless the owning entity is acting as "the agent of a natural person" (IRC Sec. 72[u][1]). The IRS, in various private letter rulings, has held that a trust may qualify for that exception, but only when all permissible trust beneficiaries are human beings. If your client wants to name a nonnatural person as owner of a deferred annuity, insist that she consult tax counsel before the application is completed.

If a non-grantor irrevocable trust is named as owner of a deferred annuity, any distributions made from the annuitant will be subject to the 10 percent penalty tax of IRC Sec. 72(q) unless an exception applies - and the over 59 1/2 exception will not apply, even if the annuitant is older than 59 1/2. The exception for becoming disabled will also probably not apply. Why? Because both exceptions refer to the taxpayer, and, if the annuity is owned by an irrevocable trust, not the annuitant.

When the Deferred Annuity Is Payable to a "Non-Natural Person"

If a deferred annuity is not owned by, but is payable to, a trust (or other non-natural person), a different landmine comes into play. IRC Sec. 72(s) states that, upon the death of "any holder" (tax-speak for any owner), the entire value of a deferred annuity must be paid out. If death is after the contract was annuitized (that is, after the annuity starting date), the contract value must be paid out "at least as rapidly as" the owner had been receiving it. There is a curious and often ignored aspect of that rule: while the annuity payments that the owner had been receiving were taxed under the regular annuity rules (in which a portion of each payment was considered a nontaxable return of principal), any refund element payable to a beneficiary (such as payments made under a "life and period-certain" arrangement) will not be taxable until all principal, including the principal portion of payments made to the owner, has been received tax-free. This is true unless the beneficiary elects a payout arrangements different from that under which payments were being made to the owner. In that situation, the regular annuity rules will apply (Treas. Reg. Sec. 1.72-11[c]).

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Dr. David Babbel Professor Wharton School

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If the owner of a deferred annuity dies before the annuity starting date (before annuitizing the contract) and if the named beneficiary is a trust (or other non-natural person), the cash value of the annuity must be paid out within five years, according to IRC Sec. 72(s)(1)(B). This is because the two exceptions to that rule don't apply unless the beneficiary is a human being. What does this mean, in practical terms?

George and Gracie Example

George dies owning a deferred annuity worth $1 million, with a cost basis of $500,000. If George's wife, Gracie, is the named beneficiary, she has four payout options available:

1. She can take the death benefit as a lump sum.
2. She can take the death benefit over five years (IRC Sec. 72[s][1][B]).
3. She can take the death benefit as an annuity over a period not extending beyond her lifetime (IRC Sec. 72[s][2]).
4. As the surviving spouse of the annuity owner, she can elect to treat that contract as though she were the original owner, and continue tax deferral (IRC Sec. 72[s][3]).

If George had named a trust as beneficiary - even his own revocable living trust, and even if Gracie were the successor trustee and sole beneficiary - Gracie would lose the last two options!

This is how the IRS and nearly all annuity issuers interpret the rules of IRC Sec. 72(s). Very few insurers would permit Gracie, as trustee of the trust named as beneficiary, to elect payment as an annuity over a period not extending beyond the lifetime of the oldest trust beneficiary. Those insurers are relying upon an interpretation of Congress' apparent intent in passing Sec. 72(s) that may be entirely valid, but for which there is no explicit authority in the Internal Revenue Code or Regulations. For a more detailed analysis of this and related issues, see Olsen and Kices, The Annuity Advisor (National Underwriter Co., 2nd ed., 2009).

Source - Insurance News Net Magazine - 11-2010