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Variable annuities and trusts: The basics

by Ed McCarthy, CFP, RICP

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I recently spoke with Larry Greenberg, president of Jefferson National in Louisville, Kentucky. Among other topics, we discussed advanced planning strategies for wealth transfers by holding variable annuities (VAs), specifically investment-only VAs (IOVAs), in trusts. It’s an intriguing but complex topic, and in this post I’ll cover the arrangement’s basic features.

How can a trust own a VA?

Your first reaction to the idea of a trust holding a VA is that the strategy will backfire and eliminate the annuity’s tax-deferral benefits. That’s a logical conclusion based on Internal Revenue Code Section 72(u), which covers cases in which a person who is not a “natural person” holds an annuity. If that section applies, the VA will not be treated as an annuity contract and the income earned will be considered ordinary income received or accrued by the owner during that taxable year. Tax rates on trusts’ retained income are high, so that would be an expensive outcome for clients looking to accumulate funds in the trust.

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But there is an exception in Section 72(u)(1)(b) for beneficial ownership. “If annuities are nominally owned by a non-natural person, but beneficially owned by an individual, then basically you can use them within a trust,” Greenberg says. That exception creates the wealth transfer opportunity by combining VA’s tax deferral with trusts’ income accounting rules. Those rules are complex and beyond the scope of this post. However, the basic principle is that the trust’s terms and local law determine what gets treated as income within the trust. As Greenberg explains, since undistributed gains within the annuity are not defined as trust income, there is no income recognition until the trustee makes withdrawals from the annuity; hence, the VA continues to grow tax-deferred.

Suitable trusts

IOVAs work well with different types of trusts, says Greenberg. These include:

    • Charitable remainder trusts (CRTs)
    • Credit shelter/bypass/family trusts
    • Net income with makeup charitable remainder unitrusts (NIMCRUTs)
    • Revocable trusts
    • Special/supplemental needs trusts

Each trust type has its own applications and requirements to optimize the benefits of holding a VA. Future posts will drill down into more detailed planning and implementation.