From the time of the ancient Phoenicians on up to a few years ago, it was standard practice that the key life to be taken into consideration for an annuity was the annuitant–the person who receives annuity payments. In life annuities, the annuitant was the person upon whose continuation of life annuity payments were based. In instances where the annuity owner and annuitant were not the same person, the annuitant was always the “measuring life.”
In modern times, annuities have been a key element not only for longevity planning but also for providing people a tax efficient method of saving for retirement or other future financial needs.
The federal income tax deferral inherent in deferred annuities has afforded many Americans the opportunity to secure a larger pool of funds for retirement. Unfortunately, when federal income taxes become an element in any financial product, the decisions made by Congress and the Internal Revenue Service often affect the products and, as in the case of annuities, can change practices that may have been in place for decades–even for millennia.
During the late 1970s and early 1980s, various types of annuities came under scrutiny by the IRS and, by reflection, Congress. Concern developed that deferred annuities were being used more as short-term tax shelters than as the retirement vehicles the federal government intended them to be. To prevent this, Section 72(q) of the Internal Revenue Code was enacted. It imposed a 10% tax penalty on deferred annuity distributions unless the distributions meet certain standards, such as attainment of age 59 1/2 , death or disability.
Concern also developed that annuity owners were likely to use deferred annuities as vehicles to defer federal income taxes for extended periods of time by changing policy ownership and annuitant designations. In essence, the concern was that an elderly owner could, upon death, pass ownership of the annuity to a beneficiary without annuitization, thereby continuing tax-deferral indefinitely. So, IRC Section 72(s) was enacted. This required minimum distributions upon death of the “holder” of a deferred annuity contract.
As is often the case with IRC changes, Congress enacted these provisions in a rush, without carefully considering all the technical requirements the changes might make to the annuity business and to consumers having interests in the products.
Since one of the exemptions to the 10% tax penalty on distributions prior to age 59 1/2 was upon death of the “holder,” it became important to establish which party to an annuity was the “holder.”
Almost immediately, the annuity industry had to deal with the question of who was the “holder” of a deferred annuity contract for purposes of the IRC. Was it the owner or the annuitant? Likewise, the death of the “holder” became the operative event to force minimum distributions–not death of the annuitant as had been the case for millennia.
The IRC also allows exemptions for “spousal beneficiaries,” making it wise to have the annuity owner’s spouse be the beneficiary of the contract’s death proceeds.
The annuity industry tried to obtain clarification that the exemption would apply upon death of either the annuity owner annuity or the annuitant. This would have resulted in avoiding the tax penalty regardless of which of the two major parties to a deferred annuity died.
Unfortunately, the IRS would not support this request. The determination was made that the deferred annuity’s owner was the “holder” for purposes of applying the exemption to the tax penalty. This had the effect of changing the way people have looked at annuities from time immemorial.
For tax purposes, the industry had to change its annuity policies to require distribution upon death of the owner, even if the annuitant were still alive. There were provisions that permitted penalty-free distributions for the life expectancy of a beneficiary (which could be the annuitant), but the annuity owner became the important life, not the annuitant.
This gave rise to a new type of deferred annuity–the “owner-driven” contract as opposed to the traditional “annuitant-driven” annuity. (See chart for definitions.) However, to comply with Section 72(s), there must also be a provision that forces distribution upon death of the owner.
What difference does it make? Consider this example: A married couple wants to purchase a deferred annuity. The couple wants its only child to have whatever assets are left after both spouses die. Often, such a couple will have the husband be the owner and, since women tend to live longer than men, the wife be the annuitant with the child as the beneficiary.
If the annuity is owner-driven and if the annuitant dies before the owner, there is no forced distribution to the child as beneficiary. However, if the annuity requires distribution upon death of either owner or annuitant and if the wife dies before the husband, the husband loses all interest in the contract (probably not their intent). The child, as beneficiary, now has all rights under the contract.
Moreover, the law states that the tax penalty is not waived upon death of anyone except the “holder”–i.e. the husband. Worse, the exemption from tax penalty for distributions under age 59 1/2 applies to the age of the person receiving distribution–not the age of the deceased or of the “holder.”
Thus, in an annuitant-driven contract where the annuitant is not the owner and the annuitant dies first and the beneficiary is under age 59 1/2 , not only does the owner lose all rights to the value of the contract, but also the beneficiary could be subject to a 10% tax penalty on the taxable portion of the proceeds as well.
We know of no cases where this problem has resulted in tax penalties being assessed. However, this clearly illustrates the necessity of having correct designations with respect to ownership and the other relationships involved in annuities.
Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the law firm of Blazzard & Hasenauer, P.C., Pompano Beach, Fla. Their email address is: firstname.lastname@example.org.