When parents transfer assets to their children, the parents sometimes use “spendthrift protection” strategies to protect the transferred assets from the children’s possible spendthrift tendencies, bad investment judgment, divorce settlements, judgment creditors or other misfortune.
Nonqualified annuities are sometimes used to meet a parent’s objective to provide spendthrift protection for assets transferred to children.
However, differences among the many types of annuities and their specific ownership and disposition provisions can complicate spendthrift protection planning for annuities.
Most states have statutes or judicial law that specifically permit “spendthrift clauses” for annuity or life insurance settlement options.
Spendthrift clauses are designed to shelter policy values or proceeds, to the extent permitted by law, from claims of creditors of a beneficiary or to any legal process against a beneficiary.
Single Premium Immediate Annuities. SPIAs frequently are used in spendthrift protection planning. These products start annuity payments to the payee within one year after the single premium is paid. Usually, they have no cash surrender value.
Under one approach, the parent owns the annuity and makes the child the annuitant, the beneficiary and payee. The child receives the annuity payments, but the parent maintains ownership rights including the right to change the beneficiary or assign the contract.
Although paid to the child, the annuity payments will be income taxed to the parent based upon an exclusion ratio. The payments are also taxable gifts to the child that should qualify for the annual exclusion (currently $11,000 per parent, or $22,000 for joint gift).
Gifts in excess of the annual exclusion require the filing of a gift tax return and possible reduction in the parent’s lifetime exemption equivalent.
Because the parent is the owner of the annuity, the fair market value of the annuity will be included in the parent’s estate.
Upon the parent’s death, the child will usually become the owner of the contract. Although most SPIAs have no cash surrender value that the child can access, the child will normally have the right to assign the annuity in exchange for money or as security for a loan.
To avoid this result, the parent may want to make the policy non-transferable and non-assignable with an irrevocable beneficiary designation upon policy issue. Frequently accomplished by a policy endorsement, this non-transferability feature will limit the parent’s ownership rights, but it will also help accomplish the spendthrift protection objectives after the parent’s death.
Under a second approach, the child is the owner, annuitant and payee of the SPIA. As owner, the child will normally have the right to assign the annuity to another person or entity, and the annuity may be subject to judgment creditors or divorce settlements.
To avoid this result, the parent may condition his or her single premium payment upon the child’s willingness to apply for a policy issued with non-transferable and non-assignable provisions from the start.
If the child surrenders the policy during the “free look” period, many insurance companies return the premium payment to the payor of the premium, not the policy owner. The annuity policy and company procedure should be examined carefully for this “free look” process.
Under this second arrangement, the child will pay income taxes on the annuity payments based upon an exclusion ratio. The premium payment is a gift to the child that should qualify for the annual exclusion (currently $11,000 per parent). Gifts in excess of the annual exclusion require the filing of a gift tax return and possible reduction in the parent’s lifetime exemption equivalent. The SPIA will not be included in the parent’s taxable estate.
Deferred Annuities. Because of the significant differences among the many types of deferred annuity policies, generalizations about their effectiveness for spendthrift protection planning is difficult.
The choice of a deferred annuity for spendthrift protection purposes will often depend upon the objectives of the parent.
If a parent wants the child to own the annuity during the parent’s life, annuities that give the owner immediate access to cash surrender values will obviously be ineffective for spendthrift protection planning. Attempts to add a spendthrift protection endorsement may be ineffective because many state statutes permitting spendthrift protection clauses in annuity contracts are generally not applicable to the original “owner” of a deferred annuity contract.
However, deferred annuities that offer low cash surrender values and good guaranteed annuitization options may offer more opportunity for spendthrift planning with the child as owner of the annuity. If the parent believes in the long-term success of equity markets, this low surrender value/good annuitization approach may be especially attractive when combined with a variable annuity.
The child may be reluctant to surrender a contract with low surrender values if the guaranteed annuity is attractive. The variable annuity feature also provides upside potential.
If a parent wants the child to receive annuity values upon the parent’s death, then the parent should consider settlement options that will annuitize over the child’s life or life expectancy.
Because the child is the beneficiary, spendthrift protection clauses should be effective in those states that permit them.
Gary Underwood, JD, CLU, ChFC, is an advanced marketing attorney for Genworth Financial, Lynchburg, Va. His e-mail address is Gary.Underwood@genworth.com.
Parents sometimes use ‘spendthrift protection’ strategies to protect transferred assets from the children’s possible spendthrift tendencies
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