Estate Planning Alert:  Estate Planning Opportunities and Pitfalls With Nonqualified Annuities


    Non-qualified annuities (i.e., annuities purchased with after-tax dollars) need to be carefully structured as part of the estate plan in order assure maximum continued tax deferral after death. 

            Every annuity has three parties: 

One common error is naming one individual as the owner and another (perhaps the owner's spouse or child) as the annuitant.  Internal Revenue Code section 72(s) requires death benefits to be paid upon the death of the owner, but if the annuitant is a different individual and dies first, the death benefits may be required to be paid prematurely (and taxed to the extent they exceed basis).  Therefore, the owner and annuitant should nearly always be the same. An exception would be with ownership by a trust, since only an individual can be the annuitant. 

            Sometimes an annuity is owned by a revocable trust to avoid probate. However, this is unnecessary, since probate can be avoided simply by naming a beneficiary. Moreover, it is not certain that the pre-age 59 1/2 early withdrawal penalty can be avoided with trust ownership, since a trust cannot attain age 59 1/2. 

            Finally, appropriate beneficiary designations can permit longer tax deferral at death. First, benefits need not begin at death if the spouse is the beneficiary – the spouse can become the successor owner, much like a rollover with an IRA or other qualified plan. Second, while the general rule of section 72(s) requires that all death benefits be paid within five years of death, a named individual beneficiary can receive benefits over his or her life expectancy. This exception is apparently not available when a trust is named as beneficiary, and most annuities apply the five-year rule when a trust is the beneficiary. 

            Given the above, the best primary beneficiary is a spouse (if any), unless there is concern about the surviving spouse's possible remarriage, in which case a QTIP trust may be a more appropriate beneficiary. If there is no spouse, individual beneficiaries have more opportunity than a trust for tax deferral. Where a trust is an appropriate beneficiary (e.g., where the beneficiaries are minors or otherwise incapable of managing a large inheritance), the trust beneficiaries generally should be named contingent beneficiaries so that, if they have passed the trust's final age of distribution when the annuity owner dies, the trustee can disclaim and permit the trust beneficiaries to become the direct beneficiaries, and each beneficiary can select a payout option. 

            Should you have any questions regarding annuities, please contact one of our Estate Planning, Trust and Probate attorneys.