Chapter 2 — Taxation of Annuities (continued)

A particularly troubling set of tax problems can arise when an annuity is owned by a trust, or a trust is named as beneficiary of an annuity. A trust is not a natural person — therefore it cannot die. This means that all trust-owned annuities must rely on a separate annuitant as the measuring life (i.e., the owner and the annuitant are necessarily different). Put another way, all trust-owned annuities must also be annuitant-driven annuities. As we learned in the previous section, annuitant-driven contracts are more likely to lead to unintended consequences than owner-driven contracts.

Problems with Trust-Owned Annuities

Financial advisors often recommend that all of a client’s assets be placed within a revocable living trust for estate planning purposes — but this recommendation is usually made without a full understanding of the tax rules governing annuities and trusts. Moreover, placing an annuity within a trust may conflict with the rest of the client’s estate plan.

In most cases, there is little benefit to owning an annuity within a trust:

• Probate avoidance: An annuity’s death benefit automatically passes “by contract” to the beneficiary, so it will pass outside probate anyway — a trust is not needed for this purpose.
• Flexible distribution: If more flexible distribution is desired, the trust could simply be named as beneficiary without also being named the owner.
• Incapacity: If there is concern the owner may become incompetent (e.g., Alzheimer’s), a durable power of attorney would address that concern more effectively.

In light of the problems that can arise from trust-owned annuities and the availability of reasonable alternatives, it rarely makes sense for a trust to own an annuity.

As noted earlier, annuities owned by a trust that simply represents a “natural person” will enjoy tax-deferred growth in the contract. If the trust has another purpose, however, the trust loses that tax-deferred status — and the trust will have to pay income tax annually on the earnings that accumulate in the contract.

Trusts Named as Beneficiary

If a trust is named as a beneficiary, a different set of adverse outcomes is possible. Since a trust cannot be a “designated beneficiary”, if death benefits are payable during the accumulation phase, they must be taken under the general five-year payout rule. The annuitization and spousal continuation exceptions apply only to designated beneficiaries (i.e., individuals — not trusts).

There are some situations when naming a trust as beneficiary may provide greater flexibility in distributing the contract’s death benefits. If the need for flexibility outweighs the less-favorable distribution rules, naming a trust as beneficiary may make sense. Financial advisors should fully understand the tax code on this issue, the wording of the contract, and the administrative policies of the annuity company before making such a recommendation.

A qualified plan is a tax-deferred arrangement established by an employer to provide retirement benefits for employees. It “qualifies” for special tax treatment if it complies with various government requirements known as the Employee Retirement Income Security Act (ERISA). A qualified annuity is an annuity purchased as part of a tax-qualified employer-sponsored retirement plan — or individuals can purchase qualified annuities within their Individual Retirement Accounts (IRAs).

How Qualified Plans Work

Monies contributed by employers or employees to qualified retirement plans are tax deductible, and earnings grow in the plan tax-deferred. This allows for more rapid growth in the plan. When monies are disbursed to retired employees, the full amount of the pension benefit is subject to tax as ordinary income — there is no exclusion ratio.

Withdrawals from qualified plans are also fully taxed as ordinary income — there is no LIFO or FIFO accounting. Withdrawals prior to age 59½ are subject to a 10% penalty, waived in the event of death, disability, or if payouts are structured as a series of substantially equal lifetime payments.

IRA Exceptions Worth Noting

A full discussion of the various types of qualified plans is beyond the scope of this program. However, a couple of exceptions are worth noting:

• Non-deductible IRA contributions: Some contributions to IRAs are made with after-tax dollars (not tax deductible). For those contributing after-tax dollars, a portion of eventual withdrawals will be tax-free return of principal, using a variation on the exclusion ratio.
• Roth IRA / Roth 401(k): After-tax dollars are contributed, the account grows tax-deferred, and if the participant keeps the contribution in the account for at least five years, withdrawals taken after age 59½ will be completely tax-free. Premature withdrawals from Roth accounts are taxed on a FIFO basis (tax-free return of principal first, then taxable earnings) with no 10% penalty.

Tax-Sheltered Annuities (TSAs) — 403(b) Plans

A Tax Sheltered Annuity (TSA), also called a 403(b) or 501(c)(3) plan, is a special type of annuity plan reserved for employees of educational and nonprofit organizations. Through these sections of the tax code, the federal government has encouraged specified nonprofit charitable, educational, and religious organizations to set aside funds for their employees’ retirement.

Funds set aside in a TSA are not included in the employee’s current taxable income. All contributions are made with “before-tax dollars” — whether the employer contributes funds on behalf of employees or the employee contributes through a salary reduction agreement. These ongoing contributions are paid into a deferred annuity (fixed, variable, or indexed). Like all annuities, earnings grow tax-deferred.

Most TSAs are primarily funded by employee contributions through a salary reduction agreement. A fixed amount is deducted from each paycheck before taxes are taken out. Both the employee contributions and any employer matching contributions are subject to limits similar to 401(k) plans — these limits are adjusted periodically for inflation.

Upon retirement, the tax-sheltered annuity can be annuitized to provide retirement benefits. All payments received are taxable income — there is no exclusion ratio, since the contributions were made with before-tax dollars and earnings grew tax-deferred. When employees retire they are usually in a lower tax bracket, so retirement income payments from the TSA are likely to be taxed at a lower rate than the income that was sheltered during their working years.

Annuities in Qualified Plans — Summary

Annuities can be used in a qualified retirement account for two different purposes: deferred annuities in their accumulation phase provide an investment vehicle during an employee’s working years, and upon retirement, immediate annuities provide a means to distribute lifetime pension benefits.

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As we’ll see in Chapter 3, many larger employers use group annuities to cover their workforce. Individual annuities are better suited for Individual Retirement Accounts, or for employers who wish to cover a few employees.