Non-qualified annuities look very much like IRAs, in that they are composed of a deferral phase (where the investment builds tax deferred) and a payout phase, but it is unclear whether the IRA Treasury Regulations for IRAs can be used to supercede the annuity contract settlement options when problems arise.
There can be a many unplanned adverse tax results or unintended payees, so it is critical that the client understand the type of non-qualified annuity contract he or she owns. In a conventional revocable trust plan, a client may be advised to transfer all assets, other than IRAs or qualified plans, to his revocable trust or to designate the trust as the beneficiary of the non-qualified annuities. These instructions may lead to adverse income tax results or to an unplanned party controlling the contract.
To understand how unplanned events can arise, it is first important to understand the parties to the annuity contract:
“Owner” – The “owner” possesses the contract rights: the right to surrender the contract for a cash lump-sum; the right to elect annuitized payouts; the right to designate and change beneficiaries; and the right to sell or give away the contract.
“Annuitant” – The “annuitant” is the measuring life of the annuity contract. It is the age of the annuitant that forces the contract to mature. If payout if based on life or life expectancy, the annuitant’s life may be used to measure the duration of the payout.
“Payee” – The “payee” refers to the person who receives the payments under the contract. A payee may have control of the payment (as in “owner”) or may be a mere payee (as in “beneficiary”). Usually one person fulfills all three roles, owner, annuitant, and payee, but these roles can be filled by three different persons and/or entities. It is when the roles are filled by different persons that unintended tax consequences might arise.
“Successor Owners” – Successor owners succeed to the contract rights at the owner’s death. Depending on the contract, “beneficiary” and “successor owner” may be used interchangeably although that is not always the case. What is important is to look at the underlying rights of the named or described party to the annuity contract.
Internal Revenue Code (IRC) Section 72 requires payout after the owner’s death. How quickly payout must occur depends on the “designated beneficiary.” (IRC Section 72(s)) The IRS is concerned with who controls the cash value after the death of the original owner. Who controls the contract will depend on the annuity contract. When the annuity contract has a successor owner feature, the successor owner only becomes the new owner if the original owner dies when the original owner is not also the annuitant. If the original owner dies while the original owner is also the annuitant, then the contract looks to the beneficiary as the person who controls the proceeds and succeeds to the death distribution. Thus, if the owner dies, but the owner is not the annuitant, the successor owner becomes the new owner, the annuitant remains unchanged, and the “beneficiary” is irrelevant.
The IRS does not require distributions on the death of the annuitant. Nevertheless there are many annuity contracts that force the contract to mature on the death of the annuitant so the owner (or other payee) is then forced to take distributions, be subject to income tax, and possibly be subject to the 10% penalty for early withdrawal if under age 59 ½.
The fact that there are many non-qualified annuity contacts that trigger distributions on either the death of the owner or the death of the annuitant creates issues that must be addressed when the annuity contact is structured. To consider this issue, non-qualified annuities are sometimes categorized as Owner Driven or Annuitant Driven. Under an Owner Driven annuity, payout occurs on the death of the owner. Under the Annuitant Driven annuity, the contract will pay out upon death of either the owner or the annuitant. The amount paid out differs.
More importantly, under Annuity Driven contracts, unintended results can arise when different persons fill the roles of owner, annuitant, and beneficiary as the following illustrations show:
Illustration #1 Annuitant Driven Contract
Owner – Husband
Annuitant – Wife
Beneficiary – Husband and Wife
Wife dies first. Husband becomes sole beneficiary, but he cannot continue the contract under the spousal continuation rules (Code Section 72(s)). The spousal continuation rules permit the surviving spouse of a deceased owner to continue the contract tax deferred. In this case there is no deceased owner because Husband continues as owner, so the death distributions must still be made.
Illustration #2 Annuitant Driven Contract
Owner – Husband and Wife
Annuitant – Husband
Beneficiary – Child
Husband dies first. The Wife, as co-owner, only becomes the new owner if the original owner dies when the original owner is not also the annuitant. If the original owner dies while the original owner is also the annuitant, then the contract looks to the beneficiary as the person who controls the proceeds and succeeds to the death distribution. In this case, a death payout occurs to the child. The Wife will not be able to elect spousal continuation. The child now controls the contract and must take the death distribution and reckon with the income tax. Further complicating this picture is whether the Wife, who was a joint owner, will be deemed as making a taxable gift to the child of her 50% interest in the contract.
Illustration #3 Annuitant Driven Contract
Owner – Father
Annuitant – Son
Beneficiary – Mother
Son dies first. Mother as beneficiary must take proceeds. No spousal continuation would be available since owner spouse did not die first.
Unanticipated problems can also arise when a trust is named as the owner or the beneficiary of a non-qualified annuity. Not every non-qualified annuity is eligible for tax deferral. IRC Section 72(u) provides that an annuity owned by a person who is not a natural person will not qualify for tax deferral. Trusts, corporations, partnerships, and LLCs are non-natural persons. There are several exceptions and the one relevant to trust ownership provides that when the annuity is held by an agent for a natural person, deferral will still be allowed. There have been a series of private letter rulings that seem to make clear that a trust taxed as a grantor trust under Code sections 671-678 will meet this exception. Typically, the standard revocable living trust converts to an irrevocable non-grantor trust upon the death of the Grantor which will take the trust out of the exception described above.
Several private letter rulings give some guidance that as long as the current and remainder beneficiaries are natural persons (i.e. not a charity), then tax deferral will be permitted. While it may be that all the beneficiaries under an irrevocable non-grantor trust will be deemed natural persons, unless the trust elects to annuitize the payout, amounts withdrawn by the trustee will be taxed as ordinary income at the trust’s compressed income tax rates until all the growth is withdrawn.
When an individual is named as the beneficiary of a non-qualified annuity, depending on the contract, he or she would have two options for distributions: complete distribution within five years of the death that triggers the payout or distributions over the beneficiary’s life expectancy (similar to the “stretch” IRA). If the deceased owner’s spouse is the designated beneficiary, continued tax deferral would also be available. (Code Section 72(s))
If a trust is the beneficiary of the non-qualified annuity, the trust must receive the balance within 5 years of the death that triggers the payout. It cannot stretch out the distributions over the life expectancy of one or more trust beneficiaries. If the spouse is the trust beneficiary, it is not clear that the spouse can take advantage of settlement options normally available to the spouse under Code Section 72(s).
Generally, when the trust as opposed to an individual is the designated beneficiary the ability to stretch out payments or continue deferral will likely be lost.
Careful structuring of the annuity contract is critical to obtain the intended tax and beneficiary result. This is especially so when different persons will fill the roles of owner, annuitant and payee. Disclaimer may not be available if successor payees are not named and even in cases where successor owners are named, under an annuitant driven nonqualified annuity, the beneficiary succeeds to the contract payout, not the successor owner. Relying on private letter rulings after the fact may not correct an adverse result.
Advanced Planning Library, “The Northwestern Mutual Guide to Nonqualified Annuities,” 2007
Tannahill, Bruce, “Are Non-Qualified Annuities Trustworthy?” Probate & Property, July/Aug, 2006, p.23.