by Paul M. League
Annuities com in two contract forms: owner driven (OD
) or annuitant driven (AD
). By "driven" we mean that certain actions occur upon death that are beyond the control of named parties to the contract, unless proper structuring is done regarding who owns, who is an annuitant, and who is a beneficiary to the contract. These structuring issues must be understood and addressed before investing in an annuity. So, to begin, we must first understand the type of annuity contract being used to make the investment and then proceed cautiously from there:
- Owner Driven (OD): Owners have all legal rights, and can change the designated annuitant as needed without any negative tax or penalties, as the contract specifies. OD contracts pay out only upon the death of the owner.
- Annuitant Driven (AD): Owners can usually be changed. It is contract specific as to whether an annuitant can be changed once the contract is issued. Also, the contract will pay out upon the death of either owners or annuitants. [In either form of contract, changes to beneficiaries (primary or contingent), may always be made.]
The way an annuity contract is structured is of critical importance due primarily to the way death benefits are paid out and in AD contracts that is based upon the death of the owner or annuitant. For this reason, most advisors should keep annuity structures as simple and clean as possible, which, in most cases, means avoiding joint owners and annuitants. In the case of spouses, naming anyone other than the surviving spouse as primary beneficiary should be avoided, or if done, a lot of caution should be used.
Before proceeding further we must understand two important rules that directly affect annuity contract structuring surrounding the event of death: The Death of the Holder Rule states that upon the death of a holder, death benefits of the annuity must and will be paid out. The "holder" is synonymous with the taxpayer/owner in any contract. In the case of a non-natural trust-owner, the annuitant is considered the owner, but only for death distributions. The IRS enacted these contract provisions after January 18, 1985 to prevent generational tax skipping. After April 22, 1987, the provision became applicable to "any holder."
The Spousal continuation Rule [IRC 72(s)] states that the deceased owner’s surviving spouse can become the contract owner. The surviving spouse can then continue the contract throughout his or her lifetime and is not forced to take a distribution. However, not all insurance annuity contracts offer the spousal continuation provision. If anyone else is named as a primary beneficiary along with the spouse, the option of the surviving spouse becoming the contract owner is usually lost. In cases where a child and spouse are named as primary beneficiaries, some companies will allow spousal continuation but only on the spouse’s remaining portion of the contract. The IRC states only that the beneficiary be a spouse; however, some contracts specify that the spousal election letter will only be sent out if the surviving spouse is the "sole" beneficiary, which is a narrower interpretation of IRC.
Death Benefits Can Come in Two Forms:
- The assets that have accumulated in the annuity investment itself, or,
- Enhanced death benefits provide the potential of greater payouts based on certain contract guarantees. The enhanced death benefits feature offers another advantage over many other types of investments.
However, in the two policy forms we are discussing, a key to death benefit payouts is to know on whose life the enhanced benefits are actually based. Is it the owner or the annuitant who triggers the enhancement? In an OD contract, death benefits are based on the death of the owner (i.e. owner driven). In an AD contract, death benefits are based upon the death of the annuitant (i.e. annuitant driven). In the case of AD contract forms, it’s interesting that distributions will occur on the owner’s death as "distributions of annuity assets" whereas on the death of the annuitant distributions come out in the form of "death benefits" (enhanced or not). This different "treatment" can bring about adverse income tax, gift tax, and premature distribution penalties to various named parties to the annuity contract.
Another adverse outcome can occur for spouses with an improper designation of beneficiaries. In the Spousal continuation Rule there is special flexibility on death benefits for spouses of owners. This rule gives the surviving spouse of a deceased owner, the right to continue to build a tax-deferred asset for heirs without being forced to take any form of distribution; therefore, the surviving spouse is not forced to take any assets until so desired. This rule is a meaningful exception to the Death of the Holder Rule noted above. Problems can and do arise when multiple primary beneficiaries are named, or primary beneficiaries other than a spouse are named. Therefore, such structuring arrangements require great care and caution.
Why is any of this important for annuity investors or their advisors? In the typical husband and wife annuity investor scenario, spouses want to continue the investment until after the second spouse dies in order to pass remaining assets onto their children. Without correct contract structuring, serious problems can affect the parties to a contract; however, if the contract is structured correctly, it’s possible to avoid the following four main pitfalls of poor annuity structuring, brought about by death, namely:
- Untimely income taxation.
- Unwanted gift taxes.
- The 10% IRS penalty.
- The loss of the Spousal Right of Continuation.
Let’s look at the following identical structuring examples under the owner-driven and annuitant-driven types of contracts to see some of the problems that can and should be avoided when structuring owner, annuitant or beneficiary designations so that you too will see the importance of these factors in proper structuring.
|Seemingly Simple and Benign, but
Problematic Spousal Structure Example:
|Annuitant-Driven Contract Form
||Wife (AD contractholder)
||Husband and Wife
In the example above, when the wife (annuitant) dies first, the husband becomes the sole beneficiary, but he cannot continue the annuity under the Spousal Continuation Rule because there will have been no deceased owner spouse – he, the husband/owner has not died! Since the only owner is the husband, distributions will be forced upon him as the sole surviving beneficiary upon the death of his wife. There are several potential problems in the following structure:
|Typical Faulty Family Structure Example:|
|Owner-Driven (OD) Contract Form|
|Owner:||Husband (Age 60) & Wife (Age 50)|
|Annuitant-Driven (AD) Contract Form|
|Owner:||Husband and Wife|
- Problem One: Under the AD contract in the above example, if the wife dies before her husband, the kids get the payout. While this may look fine, it’s not. The surviving husband/owner is subject to having made a lifetime gift to the children. After all, he "owned" 50% of the annuity. This creates adverse gift-tax consequences in the year he dies, such as a reduction to the exemption equivalent. If the kids are under age 591/2, they will be liable for the 10% penalty tax as well as ordinary income tax on any future income paid out of the contract because, upon the death of the annuitant, the beneficiary(ies) become the "taxpayer," not the owner!
- Problem Two: In the AD contract, when the annuitant-wife dies, the surviving owner/spouse is considered to have made a gift to the beneficiaries (the kids in this example) and income taxes become due. However, gifts between spouses are not subject to gift or income taxes. In contracts where a non-spousal joint owner dies, the surviving owner still maintains all "owner rights" over that contract. Under the Death of the Holder Rule, the owner immediately becomes subject to income taxes on any gain in the contract. Let’s suppose that we instead had an AD contract in which there were no joint owners, upon the death of the annuitant/wife (as shown above), there would then be a 10% premature withdrawal penalty on the owner/husband if he were under 591/2 at the time of the annuitant wife’s death.
- Problem Three: The children, not the surviving spouse, would be in full control of the assets!
- Problem Four: Since a spouse is not made the sole primary beneficiary, the surviving spouse loses the right of continuation under the Spousal Continuation Rule. In a jointly owned contract between spouses, you could instead name the beneficiary as "joint survivor owner" to avoid losing the spousal continuation option.
- Problem Five: Finally, by instead naming the kids as contingent beneficiaries the remaining assets would also avoid probate. Obviously, in the following example, it’s not possible to protect against losing spousal continuation. When advising non-spouse parties, you will want
|Non-Spousal Relationships Example:|
|Owner-Driven Contract Form|
|Owner:||Bob Older and John Younger|
|Annuitant-Driven Contract Form|
|Owner:||Bob and John|
to avoid the three remaining pitfalls of: untimely income taxation, unwanted gift taxes, and the 10% IRS penalty. This is especially relevant for gay and lesbian couples in states that don’t recognize their relationships as legal marriages; however, regardless of state law the IRS will not "look through" IRA’s or qualified plans since federal law doesn’t recognize such unions as marriages.
In the example above, a number of problems arise especially under the AD contract. Again, in the AD contract, if Bob dies first, his death forces a payout of the death benefit and/or any enhanced death benefits that may have been optionally selected. The death payout again results in a 10% penalty to the taxpayer beneficiary if he’s under age 591/2. Still, we also have not structurally avoided the problems of untimely income taxation or unwanted gift taxes. In either contract, when Bob dies before John, as joint-owner, Bob will be considered to have made a taxable gift to John equal to his 50% ownership, valued on the date of death FMV of the annuities assets. Additionally, in the AD contract, when Bob (the annuitant) dies, the surviving owner is considered to have made a gift to the beneficiary (John), and income taxes become due. Again, in contracts where a non-spousal joint owner dies, the surviving owner still maintains all "owner rights" over that contract. Under the Death of the Holder Rule, he immediately becomes subject to income taxes on any gain in the contract. If John were to die first, the annuities assets would pass to his estate. His assets would be subject to reduction in value due to the costs of probate that could have been avoided by simply naming a contingent beneficiary. Again, the gift tax problem arises out of the faulty structure, which is so often inherent in having joint-owners, specifically under non-spousal conditions.
Are There Remedies to These Aberrant Annuity Structures?
Yes, but it is not an easy road to hoe, so to speak. If you have an AD or OD contract with improper structuring, you may want to consider cashing out of it during a down market when your principal is very close to your policy value so that there would be minimal, if any, tax consequences (non-IRA’s).
Using SEPP (substantially equal periodic payment payout options), under the first of the three available methods (Annuitization, Amortization, or Minimum Distribution), you can effectively stretch out payments thereby lowering any taxes due. Note, however, that the "Exclusion Ratio," which provides that a portion of the payout is a return of principle and is therefore non-taxable, only applies to payments made under one of these three methods; namely, Annuitization.
Some advisors may recommend a 1035 exchange of contracts; however, a requirement of the Law is that exchanges must be like for like structuring. Use of the 1035 exchange is generally not advisable, on contracts where there was a step-up-in-basis before 1979 (pre 10/21/1979), but would be acceptable on contracts pre 8/14/1982 since these are grand fathered such that withdrawals from these contracts are taxed as "return of basis first" and then income-"FIFO." Bearing in mind these contract dates, if you had an AD contract with an undesirable Annuitant designation, then you could 1035 exchange it for an OD contract that has the same Owner & Annuitant designation, and after contract issue you would then be able to correct the structuring of the Annuitant since in an OD contract the Owner can (depending on the specific Insurance Companies contract) change a "faulty" Annuitant. One can employ other strategies, but clearly the best course is to structure the contract properly from the outset!
Always structure an annuity in a way that results in the least amount of negative tax and penalties upon payout of the death benefit. You’ll also want to have the maximum amount of flexibility regarding those payouts. There are four payout options upon the death of the holder/owner (these are not to be confused with contract "Annuitization Options"), and they are:
- Lump sum, within 60 days of death (insurer contract specific).
- Five-Year Rule – all money must be out of the contract by the end of the fifth year (Code 72 Rule).
- Annuitize over life expectancy, but make the decision within one year (insurer contract specific). There are several options under this category, such as 10-year certain, etc.
- Spousal continuation of contract over the lifetime of the surviving spouse (Code 72 Rule).
Death benefits or distributions that are paid out upon the death of the taxpayer/owner will result in an exception to the 10% pre-age 591/2 IRS penalty; however, that is not the case upon the death of an "annuitant" as in an AD contract. Assets that appreciate during the five-year payout are not treated as part of the "death benefit" but are instead treated as "taxable earnings" in the year earned. They also subject the taxpayer/beneficiary under 591/2, to the 10% pre-age 591/2 IRS tax penalty noted earlier.
To achieve the maximum payout flexibility in structuring your annuity try to preserve not only the first three of these four payout options but, most importantly, the fourth one; namely, the spouse’s right of continuation. The best way to accomplish this is to name one or the other spouse as sole beneficiary. In the case of jointly owned spousal annuities you should title the beneficiary as "the surviving spousal owner." If there are children, they should be named as contingent beneficiaries since by doing so you will at least preserve the first three payout options for them at the death of the second spouse.
In this next example, if the wife dies first, the husband simply names new beneficiaries, who are likely to be the kids or grandchildren. This allows him to maintain control over the asset.
Preferred Family Structure Example:
Owner-Driven Contract Form
Annuitant-Driven Contract Form
If the husband dies first, the wife gets the asset and can continue the tax deferral, and the children could ultimately receive an even larger asset because the wife is not "forced" to take distributions. Under this structure, all of the four pitfalls under an OD or AD contract are avoided!
One problem for some clients is their objection to making one or another spouse the sole "owner." It is, however, best to recommend that they do so and to also name the older of the two spouses as the owner, or in AD contracts, both the owner & annuitant should be the same, based on the reasonable assumption that the older spouse is likely to die sooner. Justification for this is found in mortality tables that show that the number of years a same aged female is likely to live beyond a same aged male is only about two to four years (ages 50-85), but as the spread in age differences increases the likelihood of the older spouse dying first is statistically much higher (doubled with a 10 year difference in ages where the younger spouse is the female). A practical solution for spousal ownership objections like this is to simply buy two separate contracts, one on each spouse.
Many designate trusts as beneficiaries or even as contingent beneficiaries of an annuity. First, there is no need to do this because annuities pass probate free, and second, trusts don’t allow for any form of spousal continuation or lifetime annuitization because a trust is considered to be a "non-natural person." (For more information on this, see the Non-Natural Person Rule that applies to contributions into annuities after February 28, 1986). Third, trusts limit payout options to only the first two options listed above resulting in a 50% reduct6ion in payout flexibility. This impedes income tax efficiencies on lesser-taxed distributions, which otherwise could be stretched out. When making a trust the owner it is important to know whether the insurance company that’s issuing the annuity views the trust as either a "natural" or "non-natural person" especially in revocable trusts (living trusts) where there are often spouses involved. If they view the owner/trust as a trust, they will not allow for spousal continuation; hence, another problem with making a trust the owner of an annuity. There is no look-through provision on non-qualified annuities (i.e. where the IRS will "look through" the grantor/trustee designation and recognize the spouse for spousal continuation rights). The "look-through provision" applies only to IRS-provided rationale for IRAs/qualified plans when a trust is the beneficiary. You should proceed very carefully when using a trust as any part of an annuity structure. Advisors should require and obtain a written letter of instruction from the client’s attorney on exactly how they want the structuring set up under an annuity contract.
Annuities are a sound investment for many, but as we have seen in the examples in this article, they must also be properly structured to achieve their fullest potential.
[Disclaimer and notes: Annuities are long-term investment vehicles designed for retirement purposes. Variable annuities are subject to market fluctuation, investment risk, and possible loss of principal. Variable annuities are not insured or guaranteed by the FDIC. IRAs and qualified plans already have the tax-deferral feature found in annuities. For an additional cost, annuities can provide other enhanced benefits including death benefit protection and the ability to receive a lifetime income. All guarantees rely on the financial strength of the issuing insurer. Annuities involve tax-penalty and contingent-deferred sales charges for early withdrawal. The contents of this article are believed accurate but are subject to interpretation. We do not offer or provide tax or legal advice or services. Please consult your own tax and legal authorities for such matters (31201rev]
Paul M. League, CFP(tm) is the Principal of League Financial & Insurance Services, a privately held company located in Beverly Hills, Calif. since 1985. League also operates and is a registered representative and investment advisor representative with the Beverly Hills Branch Office of Royal Alliance Associates Inc., Member NASD/SIPC-a SunAmerica/AIG company. League specializes in wealth creation, preservation, and expansion through individual and group benefit programs. For more information, write to P.O. Box 7007, Beverly Hills, CA 90212-7007, call (310)277-141, visit www.LeagueFinancial.com, or email Paul@LeagueFinancial.com.
Article extracted from California Broker Magazine (April 2001 issue)
Last Updated: 12/15/2002 10:57:00 AM