While annuity products are often primarily purchased with an eye toward securing retirement income, unexpected issues that can arise when a contract owner or annuitant dies can create postmortem tax problems that can now actually be addressed when the contract is purchased.
In particular, issues that can arise when the contract is annuitant-driven (rather than only owner-driven) must be carefully analyzed in order to ensure that the client’s expectations are met. Unfortunately, a client who does not fully understand the differences between owner and annuitant-driven contracts may be in for an unpleasant surprise down the road—especially if the contract is providing income for two spouses.
Fortunately, insurance carriers have developed a new form of annuitant-driven fixed indexed annuity that can help married couples avoid some of the complications that can cause both unanticipated retirement income outcomes and adverse tax consequences.
Owner- vs. Annuitant-Driven
While many clients purchase annuity products with an aim toward generating secure retirement income, an annuity product may also be useful in the estate planning context, as it can pay out a death benefit upon the death of the annuity owner or the annuitant (the individual whose age and sex is used in determining the amount of the annuity payments—also known as the contract’s measuring life).
While the owner and the annuitant are often the same person, there are circumstances in which, for one reason or another, they are not. For example, it may be the case that one individual cannot be named annuitant because the insurance carrier imposes age restrictions on the annuitant, but not upon the owner.
Additionally, if one spouse cannot be the owner because he or she is disabled, the second spouse may own the contract and name the disabled spouse as annuitant. In these instances, whether the contract is owner-driven or annuitant-driven becomes important (as does the selection of the contract’s actual beneficiaries).
As the names suggest, an annuitant-driven contract pays out a death benefit upon the death of the primary annuitant, while an owner-driven contract pays the death benefit upon the death of the owner. Generally, if two spouses are involved, the surviving spouse may wish to continue the tax-preferred annuity investment after the death of the first-to-die spouse.
If the contract so provides, a special rule may allow the surviving spouse of a deceased annuity owner-spouse to become the contract owner, thus avoiding the requirement that he or she take distributions (this is generally only the case if the surviving spouse is also the sole beneficiary under the contract).
However, in an annuitant-driven contract where the owner is one spouse and the annuitant is the second spouse (and the beneficiaries are the two spouses), if the annuitant-spouse dies first, the owner-spouse is not entitled to continue the contract (because there is no deceased owner-spouse and the death benefit is based upon the death of the annuitant-spouse), so must take distributions as the sole remaining beneficiary.
Beneficiary designations can also prove problematic. If the contract is annuitant-driven and owned by a spouse, with children named as beneficiaries, and the first-to-die spouse is the annuitant, the beneficiary-children receive the annuity death benefit distribution. This can create adverse gift tax consequences for the surviving spouse, as well as unintended tax consequences for the beneficiary children. Further, the surviving spouse may have lost an important source of retirement income.
An Emerging Joint Option
Recently, insurance carriers have developed fixed indexed annuity products that provide for a joint option that can allow the annuity death benefit to be paid to either spouse, regardless of which spouse dies first. These contracts allow one spouse to be the annuitant under the contract, with the second spouse named as co-annuitant. The spouses must also be the contract’s sole beneficiaries and must both be under the age of 85.
To determine whether this joint option is right for any given client, the contract’s additional features must be taken into consideration (especially in light of the new Department of Labor fiduciary rule that requires an advisor to act in the client’s best interests when selling fixed indexed annuities).
These contracts contain surrender charges if surrendered within a certain period (typically around seven years) and also contain participation caps that limit the level of interest that will be credited to the annuity account even if the index to which it is tied performs at a higher level.
Whether an annuity contract is annuitant-driven or owner-driven can be of critical importance—however, it is an issue that may be overlooked in a marketplace full of investment alternatives and product riders. Paying attention to this issue (which will require the advisor to thoroughly understand the particular annuity contract at issue) is one way that an advisor can prove his or her worth to a client who is considering an annuity purchase.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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