Trusts may frequently be good prospects for annuity sales. Often with large amounts of liquid assets, trustees may seek the advantages of guarantees, tax deferral or the limited downside risk that annuities and their riders may provide.
Although an annuity may be appropriate purchase for many trusts, questions should be asked before making a purchase. Among them:
? Is the trust permitted to buy annuities? The trust language and state law should be examined.
? What is the trust’s investment objective? Does this objective square with the risks, benefits, costs and limitations associated with the annuity product under consideration? Is upside potential or downside protection desired? Consider whether annuity riders will help meet the investment objectives.
? Is the trust a qualified retirement plan trust under Section 401? If so, then issues respecting plan qualification, discrimination, administration and distribution may be raised. This article is primarily considering non-qualified trusts, but many of the questions referenced here may also apply to qualified plan trusts.
? Who are the trust beneficiaries and what are their beneficial interests? Will an annuity purchase impinge on any beneficiaries’ rights? The rights of both income and remainder beneficiaries must be considered.
? What income distributions does the trust require? For example, must all income be distributed to a surviving spouse? If so, the purchase of a deferred annuity may impair the spouse’s income unless the trustee has the power to withdraw appropriate amounts from the annuity each year. Guaranteed living benefit riders may be helpful in such situations.
? Would the trust qualify as an exception to the non-natural person rule? For example, are any trust beneficiaries (even contingent beneficiaries) not individuals? If they are not individuals for the purpose of the non-natural person rule, any gain in the annuity contract would be taxed as ordinary income to the owner each year.
IRC Section 72(u)(1) provides that if an annuity contract is held by a trust or other entity as an agent for a natural person, then the contract will be treated as an annuity contract and tax deferral will not be lost under ?72(u)(1). If a trust beneficiary is a business or corporation, then this “trust exception” would not apply.
? Is spousal continuation of the annuity desired after the death of the annuitant? If so, trust ownership may not be the best choice. See discussion below.
? Is it expected that the beneficiary will annuitize the annuity death benefit upon the death of the annuitant? If so, trust ownership may not be the best choice.
? Will trust beneficiaries be receiving distributions from the trust before age 59 1/2 ? If so, the 10% federal tax on premature distributions may apply to the portion of these distributions that represent gain in the contract.
? What type of trust is considering the purchase?
Trusts differ significantly, and therefore the suitability of an annuity purchase will also vary with the type of trust that considers the purchase. However, many trusts do present specific tax issues that should be addressed in light of the client’s objectives.
Issues and client objectives
? Trust should be the beneficiary. The trustee must normally name the trust as the annuity beneficiary; otherwise the trustee may violate his or her fiduciary duty to the trust beneficiaries.
For example, if X is the annuity beneficiary and Y is the trust beneficiary, then upon the annuitant’s death, X may be entitled to the death proceeds under the terms of the annuity contract. However, under the trust, Y should have received the death proceeds. For the reason illustrated by this example, many insurance companies make the trustee the owner of the annuity upon the death of an annuitant, and contractually override the beneficiary designation, if it is different from the trustee.
? Spousal continuation. Spousal continuation of the contract may not be available when a trust owns a non-qualified annuity. However, for many clients, spousal continuation is not as important as other benefits that an annuity may provide.
Under IRC ?72(s)(6), the death of an annuitant forces distribution as a lump sum or over five years for non-qualified deferred annuities held by a non-grantor trust. Since the trust (not the surviving spouse) is normally the annuity beneficiary, a surviving spouse has no rights to elect spousal continuation for non-qualified annuities.
For grantor trusts, the death of the grantor (the owner for tax income tax purposes) usually forces distribution of the annuity proceeds. An exception to this rule may arise if a trust continues to be a grantor trust after the death of the grantor (i.e., where the surviving spouse was co-grantor).
? Annuitization or stretch for beneficiaries. Annuitization as a payout option for the trust beneficiaries upon a triggering death may not be available if a trust is the owner or beneficiary of a non-qualified annuity. This factor may or may not be important to the grantor and trust beneficiaries.
As stated above, the trust must normally be the annuity beneficiary. For non-qualified annuities, the death of an owner (or annuitant if the trust is owner) forces payout as a lump sum, over five years, or as either an annuity or stretch payout for a period not exceeding the life expectancy of the beneficiary under IRC ?72(s)(6).
However, a trust has no life expectancy, therefore an annuity cannot be paid over a period of time determined by the trust’s life expectancy. Consequently, the death proceeds must be paid as a lump sum or over 5 years to the trust. The trust will then distribute the proceeds to the beneficiaries according to the terms of the trust.
Trusts with annuities may have tax, spendthrift, diversification and other protection advantages, especially if they are designed to purchase and hold annuities. However, when placing an annuity inside an existing trust, the trustee and legal advisor should check the trust document and state law carefully.
Gary Underwood, JD, CLU, ChFC, works in advanced marketing at Genworth Financial, Lynchburg, Va. You may e-mail him at