We recommend trusts to so many clients that it feels like they’re never a bad idea. But one client had a question regarding using a trust for a different reason than the usual estate planning purposes. He wanted to know if it is ever a good idea to put an annuity into a trust. He wanted to start saving for and possibly funding his beneficiaries while he was still alive.
This isn’t an entirely unusual scenario. In some cases, it can work to hold an annuity in a trust, provided you’re pairing the right annuity with the right trust. More often than not, the annuity recommendation does not involve a trust, but every case is different.
Using a Deferred Annuity in a Trust
Unlike brokerage assets or cash at the bank, annuities always have named beneficiaries and upon death the proceeds are paid out contractually per those beneficiary provisions. The assets within the annuity are asset protected to varying degrees in most states regardless of whether or not the annuity is held in a trust. In addition, some of the newer “stretch provisions” that allow your beneficiaries to distribute annuity income over their lifetime are unavailable with trust owned annuities. As a result, we often question the client and the attorney as to why they prefer an annuity to be trust owned. In many cases, it is simply an old habit, and the attorney and CPA are often unaware of the downsides that may exist. A simple discussion will establish the correct form of ownership.
Holding an Annuity in an Irrevocable Grantor Trust
In the case in which a trust is holding a deferred annuity for the ultimate benefit of others, you’d want to look at using a grantor irrevocable trust. Using the irrevocable trust allows you to make cash gifts using your annual gift tax exclusion. The trust uses the cash to purchase annuity policies with you as the named annuitant. When those annuities start paying out, the payouts go to the trust, who can distribute funds to beneficiaries. The beneficiaries must be living people, not entities, for this trust to be considered outside of your estate.
This can be a good way to shift some of the tax burden out of your estate if you’re in good health and want to provide ongoing funding for beneficiaries. This tactic can allow you to create funding while you’re alive and get your legacy started early.
However, when you pass away, the rules of the annuity will change. The trust will only have two options. It can either take the annuity out as a lump sum or take it in a series of payments over five years. This is where those who use this tactic run into problems.
When You Shouldn’t Use an Annuity in a Trust
Annuities can be a bit trickier to use in a trust when the annuitant passes away. Because the contract is based on your life, it can only pay out steady payments while you’re alive. Once you pass away, the annuity contract will need to be dissolved, and your trust is going to take a tax hit.
The taxes on earnings on the annuity become due as you’re withdrawing them. The big benefit of annuities is the tax-free growth while you’re alive. When payments come out, they need to be structured so the paymets will last awhile to lower the tax hit.
Consider this scenario. A man buys an annuity for $500,000 that, at his death, is worth $1 million. If the annuity is in a trust, the trust must receive payments over a maximum period of five years. That means $500,000 of taxable income will have to be included in that trust’s tax return over the next five years. Now, when the beneficiary is a natural person, he or she can stretch an annuity payment out over his or her entire life by essentially becoming the annuitant or by using a “stretch provision.” Trusts can’t do that because trusts don’t have lifespans.
In some cases, it might be a better idea to simply buy the annuity for someone else to be the annuitant. When you do that, it’s best not to put it in a trust. Courts have found that the grantor is considered the “annuitant” on any policy in the trust because they’re the one who funded it through donations.
Using an annuity within a trust is not usually necessary. If your attorney has a special reason for doing so, we naturally set the annuity up as instructed. However, since annuities are already tax deferred, already have a named beneficiary, and are probate free, they are often not needed at all.
For more information on this topic or to further discuss your estate planning, contact us at 800-DIE-RICH.