Both trust entities and annuity products can play powerful planning roles for clients in a variety of situations—but unfortunately, when the two strategies collide, the tax consequences can be disastrous. This is especially true in the case of deferred annuity products, which are typically purchased with a view toward both future income security and tax deferral.
Whether a trust is to be named owner or beneficiary of the annuity contract at issue, the client purchasing the contract needs to be aware of the serious tax consequences that can result from involving a trust in the transaction. Fortunately, for clients who have legitimate reasons for involving a trust, there may be ways to structure the transaction to include the trust entity while avoiding the tax headache.
Trust as Annuity Owner or Beneficiary
When a non-natural person (essentially, a non-human being, such as trusts, business entities, etc.) owns a deferred annuity product, the tax benefits afforded to annuities no longer apply. This means that income on the contract will be taxed as ordinary income each year (similarly to a mutual fund investment). As a result, the tax deferral benefits traditionally offered by the annuity are lost—and the compressed income tax rates applicable to trusts may apply (trusts are taxed at the highest 39.6% income tax rate when income exceeds only $12,400 in 2016).
Clients should note that immediate annuities are specifically exempted from this non-natural person rule. Annuities held by retirement plans are similarly exempt.
(Check out more tax planning tips at ThinkAdvisor)
Further, when a trust is named as beneficiary of an annuity contract, several of the more favorable distribution options (i.e., using the beneficiary’s life expectancy to stretch the value of tax deferral) are lost. The trust beneficiary will be required to take the annuity proceeds as a lump sum, or over a five-year period after the original owner’s death—rapidly accelerating the tax liability associated with the contract.
This is because most insurance carriers find that a trust, unlike a human being, does not have a life expectancy. Further, the option for a spouse to choose to treat the annuity as if it were his or her own (and continue the contract as such) is also lost when a trust is named beneficiary.