Trusts may present good sales opportunities for annuities. Trustees who hold large amounts of liquid assets frequently seek the advantages of guarantees, tax deferral, or the limited downside risk that annuity riders may provide.
Trust grantors, trustees, and beneficiaries are paying attention to the unique characteristics of guaranteed minimum withdrawal benefit (GMWB) riders, guaranteed minimum annuity benefit (GMAB) riders, and roll-up death benefit riders, which presents planning options.
However, trusts vary as much as their beneficiaries do. Some trusts are designed to hold annuities with income benefit riders. Other trusts cannot hold annuities at all. But, most trusts fall between these two extremes. Numerous factors determine the suitability of a specific annuity and annuity rider for trust ownership. To make our discussion more manageable, we will focus on common types of unified credit trusts.
Who Benefits
Under The Trust?
The trust document should be examined to determine the trustee’s powers and the beneficiaries’ rights. Does the trust allow investments in annuities? What is the trust’s investment objective? Variable annuities with GMWB and death benefit riders may offer the upside potential with downside protection that a trustee may find attractive.
What income distributions are required by the trust? The trust language and state law should be examined. Many state laws do not consider gains inside of an annuity contract to be income. Unless the trustee has the power to make withdrawals from the annuity, an annuity may decrease the income that might normally be paid to the income beneficiary.
Who are the trust beneficiaries? Will an annuity purchase impinge on the rights of any beneficiary? The rights of both income and remainder beneficiaries must be considered.
Example 1
Husband, H, left $2 million to his unified credit trust upon his death. His wife, W, is the income beneficiary. Their two children, A and B, are the remainder beneficiaries. A and B are also the trustees. W wants to take minimum income from the trust and let the gains accumulate for eventual distribution to her children. With the trust funds, A and B purchase $500,000 of bonds and a $1.5 million variable annuity with a GMWB rider that allows a withdrawal of 5% per year.
Under state law, gains inside the annuity are not classified as income for distribution until they are withdrawn by the trustees. Under the terms of this trust, the trustees have no obligation to withdraw income from the annuity for W. However, A and B gladly withdraw 2% from the annuity each year as requested by W.
Example 2
The facts are the same as above except that A and B are children from a previous marriage and W is not their mother. W does not want to limit her income. W has an annual income from only $500,000 unless A and B decide to take withdrawals from the annuity. (W may have an action for breach of fiduciary duty). As you can see from these examples, the circumstances largely determine the suitability of the annuity purchase. The state law definition of “income for distribution” works well with the wishes of the income beneficiary in Example 1. But the same rule works against the desires of the income beneficiary in example 2.
When Is The Trust Buying The Annuity?
Another consideration is timing of the purchase by a trust. A trust can change significantly, which may have a bearing on when an annuity should be purchased. For example, a trust may start out as a revocable grantor trust. But it normally becomes an irrevocable non-grantor trust when the grantor dies. This kind of change can have a significant effect on the tax status of a trust and the suitability of an annuity purchase.
Grantor trusts may present obstacles. Under grantor trusts, the grantor is considered the owner of trust assets for income tax purposes. Annuity proceeds must be distributed when an owner dies. Generally, trust-owned annuity proceeds must be distributed as a lump sum or over five years after the grantor dies. This is because the grantor is considered the owner. Any gains are taxable to the trust or trust beneficiaries at that time. No continuation or life expectancy payouts may generally be made unless there is an unusual situation, such as the spouse being a special co-grantor.
Credit shelter grantor trusts can be particularly challenging. The objective is usually is to pass the maximum after-tax amount to the heirs upon the deaths of the grantor and spouse. However, suppose that a credit shelter grantor trust owns an annuity. The distribution of the annuity is required upon the grantor’s death and income taxes must normally be paid on the gains. This means that the full benefit of the unified credit may not be realized.
Example 3
H creates an inter vivos credit shelter grantor trust with his spouse, W, as income beneficiary for life. His two children, A and B, are remainder beneficiaries. H transfers a variable annuity with the basis of $1 million to his grantor trust (The transfer does not trigger income tax because grantor is the tax owner).
When H dies, the annuity is worth $2 million. Assume that the trust has to pay $350,000 in taxes on the gain. Only $1.65 million is left in the trust. Also, $350,000 of the $2 million possible unified credit amount has been wasted if W dies two months later and there is no growth in the trust. (That could have passed tax free to the children under the unified credit trust).
However, it may be more suitable to make annuity purchases after the grantor has died. Upon the grantor’s death, the trust normally becomes an irrevocable non-grantor trust.
Example 4
The initial facts are the same as in Example 3, except that H funds the trust with cash. After H’s death, the trust purchases two annuities with GWMB and stepped up death benefit riders. A and B are annuitants of one annuity each. When mother dies 10 years later, assume that the annuities are worth $1.5 million apiece or a total of $3 million. These annuities may be transferred to A and B and no income or estate taxes have to be paid upon the transfer and termination of the trust.
Who Is The Annuitant?
The choice of annuitant can be important for trust-owned annuities because proceeds must generally be paid out to the trust when an annuitant dies. GMWBs may be paid longer if you choose a younger annuitant. However, if the annuitant is younger than 59½, the 10% penalty tax on premature distributions may apply to the taxable part of any withdrawals from the annuity (Under Internal Revenue Code (IRC) § 72(q)). On the other hand, choosing an older annuitant might cause the gains to be taxed sooner than they would if a younger annuitant were chosen.
Example 5
The facts are the same as in example 4, except that the trustee takes withdrawals from the two annuities on A and B. In this example, A and B are both under 59½ and a 10% penalty tax must be paid on any taxable portion of the withdrawals. The trustee then pays these withdrawn funds to W during her lifetime. The annuities are worth a total of $2.6 million upon W’s death. But the annuities are still transferred to A and B with no forced distribution of the annuity proceeds upon W’s death.
Example 6
The facts are the same as in Example 4, except that the trustee makes W the annuitant of the two annuities. When W dies, the annuities receive a stepped up death benefit and the total value is $3 million. However, annuity proceeds must be paid to the trust. The approximated $1.35 million in gains are to be taxed at 35%. This leaves A and B about $2.53 million to invest instead of the $3 million they would have gotten if they had been annuitants and no distributions had been made to W.
Is Spousal Continuation
or Lifetime
Distribution Desired?
If a trust is the annuity’s owner or beneficiary, it may not be possible to have spousal continuation of a non-qualified annuity upon death. Under Internal Revenue Code (IRC) § 72(s)(6), if a non-qualified annuity is held by a trust for a person, the death of the primary annuitant forces distribution of annuity proceeds. The annuity proceeds must be distributed as a lump sum or over five years if the first to die spouse is the annuitant or joint annuitant.
If a trust is named as the designated beneficiary, it is usually the owner of an annuity. Otherwise, the trustee could violate their fiduciary duty to the trust beneficiaries who are not named as the annuity beneficiaries. Even if the trustee designates the surviving spouse as the annuity beneficiary, many annuity contracts override the designation and make the trust the designated beneficiary immediately upon the death of an annuitant.
Consequently, upon the death of a spousal annuitant of a trust-owned non-qualified annuity, the surviving spouse is not normally able to exercise the right of spousal continuation under IRC § 72(s). Death proceeds must be distributed to the trust as a lump sum or over five years. Distribution over life expectancy is not possible because the owner, which is the trust, has no measurable life expectancy.
Interestingly, qualified accounts, such as IRAs, have a similar rule under IRC § 401(a)(9)(E). It states that the designated beneficiary must be a person. However, if the conditions stipulated in Reg. § 1.401(a)(9)-4, A-5(b) are met, Treasury regulations permit a trust to “see-through” to the trust beneficiaries and use their life expectancies for minimum distribution purposes. Unfortunately, there is no similar regulation for non-qualified annuities.
Example 7
H creates an inter vivos credit shelter grantor trust with his spouse, W, as income beneficiary for life. His two children are the remainder beneficiaries. The ith a stepped-up death benefit rider. The trustee makes H the annuitant in order to secure the stepped-up death benefit for W upon the death of H and continue the annuity until W’s death.
Even if the annuity contract allowed W to be the designated beneficiary, the trustee decides the trust must be designated as beneficiary. Otherwise, the annuity proceeds will be paid to W upon H’s death and the trustee’s fiduciary duty to the child beneficiaries may be breached. Such a payment would also defeat the estate tax objectives of the trust.
Upon H’s death, the trustee discovers that spousal continuation is not possible. As the owner and designated beneficiary, the trust does not qualify as a spouse for purposes of IRC § 72(s). However, this may not be a significant disadvantage if they don’t mind paying taxes now. The trust might take the after-tax proceeds and purchase another annuity with the surviving spouse as annuitant.
If H decides that spousal continuation is an important objective, he might consider removing funds from the trust and purchasing an annuity outside the trust. A similar issue arises for non-spouse annuity beneficiaries who want to take death distributions over their life expectancies. As discussed above, the death of an annuitant forces distribution of non-qualified annuity proceeds to the trust. Since the trust has no life expectancy, it must take distributions within five years. With non-qualified annuities, the option of stretching the distributions over the life expectancies of the trust beneficiaries’ is generally not available.
Use Funds Outside The Trust?
Using funds outside the trust or even transferring money out of the trust may be the best approach if the purchase of an annuity is desired. Again, the facts of the case and the overall objectives must be considered.
If funds are being held in a trust simply to avoid probate, the estate owner may find that an annuity can meet the same objective, sometimes at less cost. In addition, annuity payouts can sometimes be stretched over the lifetimes of the spouse and children.
Example 8
H has a grantor credit shelter trust primarily to avoid probate costs. The size of the estate is less than $2 million. H and his spouse, W, jointly purchase an annuity with GMWB and stepped-up death benefit riders. They are joint annuitants and their child, C, is the beneficiary. When H dies, the annuity proceeds are not part of his probate estate. W continues the contract. Upon her death, the proceeds can be paid out to C as a lump sum, over five years, or over C’s life expectancy.
Example 9
H has a $5 million estate. He put $2 million in a unified credit trust and $3 million in an inter vivos marital deduction trust for his wife, W. The husband and wife want to purchase an annuity with GMWB and stepped up death benefit riders, but they do not like what happens when either of the trusts owns the annuity. H transfers $1 million out of his marital deduction trust and purchases an annuity. H and W are joint annuitants with their child, C, as the beneficiary. H and W withdraw from the annuity until their deaths. C takes distributions over her lifetime after W’s death.
In Conclusion
Other issues present interesting discussions beyond the scope of this article, such as the taxation of transfers to or from a trust, IRC§ 1035 exchanges, and non-natural beneficiaries of a trust. Knowing the details of the trust document is essential. All planners should work with the trustee to make sure the annuity design fits the scope of the trust document and the objectives of the trust.
––––––––––
J. Gary Underwood, JD, CLU, ChFC, is an attorney in the Advanced Marketing Department at Genworth Financial. Gary’s career includes prior positions as an advanced marketing attorney and the president of a firm that marketed financial services to doctors. Gary received his bachelor’s degree from David Lipscomb University and his law degree from Vanderbilt University School of Law. Author of over 100 articles in law reviews and financial publications, his article on “Leveraged Split Dollar” won the best article of the year award from the CLU Journal. He also authored Doctor’s Guide to Capital Accumulation and Protection. Genworth Financial Inc. (NYSE:GNW) is a financial security company meeting the retirement, longevity and lifestyle protection, investment and mortgage insurance needs of more than 15 million customers. It has a presence in more than 25 countries. For more information, visit www.genworth.com.
