“I just do not need the income.”
As a financial advisor, you probably don’t hear that statement very often. However, if your client is a widow or widower who is the beneficiary of an existing credit shelter trust, this sentiment is fairly common. In order to not pay the taxes at the trust level, all income from a CST must be paid out to the surviving spouse.
While some surviving spouses may welcome the income, all too frequently this income only increases the tax liability for the surviving spouse. This potentially unexpected tax liability may leave your clients wondering what options are available to them.
To avoid these taxable distributions, advisors often suggest the client purchase life insurance inside the credit shelter trust. In this scenario, the CST purchases life insurance on the life of the surviving spouse. If a cash value policy is used, the cash value grows tax-deferred; and ultimately the death benefit distribution is paid to the trust beneficiaries, income tax and estate tax-free.
Unfortunately, in many CST situations, the surviving spouse may be unable to purchase a life insurance policy due to advanced age or poor health. In this case, a tax-deferred investment may be an attractive option–hence the concept of purchasing an annuity contract within the CST.
When a non-natural owner purchases an annuity contract, the annuity generally no longer receives the benefit of tax deferral. One exception to this rule is the agent exception. Essentially, if an annuity contract is owned by a non-natural person for the benefit of, or as an agent for, a natural person, the benefit of tax deferral is not lost.
For example, in private letter ruling (PLR) 200018046, the Internal Revenue Service determined that a trust owning a group annuity for the benefit of an individual retains the benefit of tax deferral. Furthermore, there have been several other PLRs, including PLR 199905015, in which an annuity owned by an irrevocable trust also continued to receive the benefit of tax deferral.
One option is for the credit shelter trust to purchase an annuity on the life of the surviving spouse. During the life of the surviving spouse, the annuity remains tax deferred. Should the surviving spouse need any of the cash value, the trustee can request a distribution from the annuity contract. Upon the spouse’s death, the death benefit is paid to the trust and distributed according to the underlying trust document. Unfortunately, these distribution options are limited.
As an alternative, the CST could purchase an annuity on the life or lives of the child or children, with the trust being both the owner and beneficiary. Consider the following example: A family with two children establishes a credit shelter trust with $1.2 million dollars. The trustee purchases two annuity contracts worth $600,000 dollars each, one on the life of each child, with each child being the annuitant on their own contract.
During the lifetime of the surviving parent, the trust will own the contract. Upon the death of the surviving spouse, the trust could distribute each contract to each annuitant in a tax-free exchange. The end result is that each child becomes the owner of his or her annuity contract based on his or her own life, with no requirement of immediate distribution. As the owner of the contract, the child can make his or her own investment choices. Furthermore, additional distribution options are available upon death, including spousal continuation.
One disadvantage of this technique is the issue of income taxation. Should the surviving spouse need access to the cash value while the annuitant is under the age of 59 1/2 , a 10% federal tax penalty could apply because of the premature distribution. Likewise, even after the death of the surviving spouse, should the new owner/annuitant need to withdraw any of the cash value, the penalty for premature distributions would be an issue if the owner were under age 59 1/2 .
Finally, many investment options are available when working with an irrevocable trust. In fact, depending on the client, almost anything could be used. However, if income tax liability and underlying investment freedom are concerns, a life insurance policy or an annuity contract could provide income tax deferral and a tax-efficient means of trust asset distribution.
Sonja Hayes is a director for the Retirement & Wealth Strategies Group at Jackson National Life Distributors LLC. Headquartered in Denver, Colorado, the company is the sales and marketing arm of Jackson National Life Insurance Company, Lansing, Mich. She can be reached at .