When producers think about how a trust can be funded, the first thought that comes to mind is usually life insurance. What many advisors don’t realize, however, is that annuities also have a role to play. Indeed, annuities are frequently the sole vehicle that insurance professionals turn to for achieving a range of estate planning objectives–from providing for the children of a first marriage to establishing a multigenerational legacy through a family foundation.
Why place an annuity in trust? Experts interviewed by National Underwriter point to several key reasons, not least among them the fact that an individual establishing a trust–the grantor–often needs an annuity’s death benefit to substitute for life insurance. That’s because many individuals are uninsurable, or would otherwise pay a prohibitively high premium for a life policy, due to a pre-existing health condition.
Also to weigh is the annuity’s favorable tax treatment. Like life insurance, annuities grow tax-deferred. And when held inside an individual retirement account, income distributions can, upon the death of the annuity owner, be stretched out over the life of a designated beneficiary. The beneficiary thus avoids a potentially large income tax hit that otherwise might apply under Internal Revenue Code Section 72, which requires that distributions be paid within 5 years of an owner’s death.
Of potentially greater value to clients, observers say, is the annuity’s ability to ensure that funds intended for beneficiaries remain intact–or are enhanced. Often trust assets are whittled away due to poor market performance, an ill-considered investment allocation or excessive distributions. By attaching, for example, a guaranteed minimum income benefit (GMIB) rider to a variable annuity held in a charitable remainder trust, the annuity owner can lock in predetermined payouts for income and charitable beneficiaries, regardless of market conditions.
“There is enormous interest among trustees in variable annuities now,” says Gary Underwood, an advanced marketing leader at Genworth Financial, Richmond, Va. “They’re especially interested in VAs because of the living benefit riders that provide upside potential and downside protection in a bear market.”
Benjamin Hill, a certified financial planner and president of Wealth Enhancement and Preservation, West Lake Village, Calif., agrees, adding: “The big insurance carriers are offering better guarantees than in years past. The riders are way more competitive, and fees have come down. This is great for the industry.”
Observers caution, however, that planners need to weigh a number of factors before recommending that a client fund a trust with an annuity. Underwood, who spoke on the topic at LIMRA International’s Advanced Sales Forum in Chicago last month, identifies 9 key issues. Among them: whether Internal Revenue Code rules permit the trust to own the annuity; whether, for tax-deferral purposes, the annuity qualifies for the exception to “the non-natural person” rule; whether the annuity’s features help to achieve investment objectives; and whether the trust is a qualified plan subject to non-discrimination testing.
Also to consider are the interests of the trust beneficiaries and whether they conflict with or complement one another; whether the annuity qualifies for spousal continuation, a stretching of the death benefit and the exception to the rule governing premature withdrawals; as well as the state treatment of income distributions.
Sources emphasize that not all trusts lend themselves to annuity funding. Example: the qualified terminable interest property trust, a marital deduction trust that is generally used to protect assets for children from a first marriage while providing income to a spouse from a second marriage during the individual’s lifetime. Because undistributed gains inside an annuity are not defined as income in most states, an annuity may not be appropriate for a QTIP.
“The trustee may be placed in the uncomfortable position between a surviving spouse who wants to maximize income and children [of a first marriage] who want to maximize principal,” says Stuart Dollar, an advanced marketing leader at Genworth Financial and Underwood’s co-presenter at the LIMRA session.
Even when the trust itself is not at issue, the timing of its funding can yield negative tax consequences. Consider the credit shelter trust (a.k.a., family or bypass trust), which married couples use to shield themselves from estate tax by leveraging the $2 million estate tax credit afforded each spouse. When funded as a revocable grantor trust before the first spouse dies, the annuity can get hit with the 5-year distribution rule upon that individual’s passing. What is more, any contract gain will be taxed at high trust tax rates unless the entire distribution is paid to an income beneficiary, such as a surviving spouse.
A better solution, says Dollar, is to make the CST an irrevocable non-grantor trust after the first spouse dies. If the surviving spouse doesn’t need the income, the vehicle’s annuity can continue to growth tax-deferred, thereby shielding trust assets from estate tax and income tax. And if children (as opposed to a surviving spouse) are designated as annuitants, the annuity can continue to grow tax-deferred upon the second spouse’s death.
Amy Renzi, a regional vice president, of advanced annuity sales at ING Americas-U.S. Financial Services, Hartford, Conn., says annuities have enjoyed wide adoption inside credit shelter trusts, in part because of the CST’s generally long time horizon, which dovetails with the annuity’s purpose. As compared to, say, a grantor-retained annuity trust, which might sunset after 2 or 3 years, the CST’s life will typically extend over 20 years or longer.
Long time horizons are also characteristic of trusts with a philanthropic objective, such as the net income with make-up charitable remainder unitrust. When funded with an annuity, says Hill, a NIMCRUT lets a trustee control the timing of distributions and, thus, maximize the tax-deferred build-up of trust assets.
“If the goal is to defer [income] taxation, annuities are great for the NIMCRUT,” says Hill. “The downside of using an annuity in a NIMCRUT or other charitable trust is that clients give up the potential for long-term capital gain treatment of distributions.”
For others, the goal is not tax-deferral, but securing the means to pay for life insurance that would otherwise be unobtainable or prohibitively expensive because of a pre-existing medical condition. Scott Keffer, president of Wealth Transfer Solutions, Pittsburgh, Pa., says a solution he frequently recommends in such instances is the purchase of a medically underwritten immediate annuity, to be held (along with a life policy) inside an irrevocable life insurance trust. Because of the client’s shorter than average life expectancy, the annuity will offer a higher monthly payout than one offered to a healthier individual.
The benefit: The annuitant can use the additional income stream to purchase a life policy for the ILIT. If the purpose is to replace an older life contract, says Keffer, the client might also look to the new policy to reduce premiums or lengthen the guarantee of a no-lapse universal life contract.
“The life-only [immediate] annuity and the no-lapse guaranteed UL contract have proven to be a very good combination because of the leveraging that occurs in the marketplace between the rate of return on a lifetime annuity and the pricing of the no-lapse guarantee,” says Keffer. “The result is increased benefits for the client.”
Yet another option for clients desiring to jettison a pricy or under-performing contract is to first sell the policy through a life settlement, then secure a heath-rated immediate annuity to pay for a new life contract offering more favorable terms. In all cases, says Keffer, the advisor needs to thoroughly shop the market before deciding on a new policy because of the often widely varying terms offered by carriers to applicants with medical conditions.
Irrespective of the planning objectives, sources emphasize that the owner, annuitant and beneficiary of an annuity must be properly designated; and these designations need to dovetail with those listed in trust documents. When this fails to happen, serious tax consequences can result.
“Many agents don’t understand the after-death implications of annuities,” says Ferris. “In 9 out of 10 cases, annuity beneficiaries are surprised to learn that there is an income tax hit and that there may be an estate tax hit because the agent or broker never told them.”