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Selecting the Owner, Annuitant, and Beneficiary for a Nonqualified Deferred Annuity
By Mel J. Massey, JD, CLU and Lawrence J. Owens, JD, MBA, CLU, ChFC

Life insurance agents and buyers often are puzzled by the possible owner, annuitant, and beneficiary combinations to be named in writing a nonqualified deferred annuity. The annuity application must be completed carefully to assure that the buyer’s goals are satisfied because the various choices lead to differing consequences…both tax and non-tax.

Selecting an owner: The owner of a nonqualified deferred annuity is the person with total control of the contract prior to the annuitant’s death. During the annuitant’s lifetime and before the maturity date, the owner may transfer policy ownership, change the beneficiary, make partial withdrawals, or completely surrender the contract for its cash value. Distributions during the annuitant’s life are taxed to the owner; the 10% penalty tax before age 591/2 is based on the owner’s age.

In most instances, the owner should be one person- the person whose money buys the contract. Other forms of ownership may be desirable in limited circumstances.

Joint ownership: Joint ownership was more common in the past than today. Previously, a parent, age 50, might buy a deferred annuity with a child, age 25, as the joint owner and annuitant. The parent set the maturity date at the annuitant’s 85th birthday. The child owned the contract after the parent’s death and income tax deferral of up to 60 years was possible.

The Tax Reform Act of 1986 amended Inter Revenue Code (IRC) Section 72(s)(1) to require annuity contracts be distributed within five years. The law effectively disallows long periods of tax deferral through joint ownership arrangements.

Joint ownership also was used to assure a surviving spouse could continue the contract if desired. Today, joint ownership isn’t necessary to achieve this goal; IRC Section72(s)(3) enables a surviving spouse beneficiary to continue a contract whether or not jointly owned. Some people suggest joint ownership between a parent and child assures the child access to the money in case Mom or Dad needs the annuity fund to pay nursing home or medical expenses. Not only may there be adverse income tax consequences to such an arrangement, but there’s a superior alternative: make Mom or Dad the sole owner, but give the child a power of attorney.

Tax consequences of joint ownership: A misconception about joint annuity ownership is that it’s similar to an “either-or” bank account. These are bank accounts in which a party, such as a parent, establishes the account and arranges the signature card so that either the parent or a child may write checks against the account. A completed gift occurs when, if ever, the child actually makes a withdrawal.

A joint annuity is not treated this way. Instead, it’s a joint tenancy with right of survivorship. The arrangement has many ramifications. Signatures of both owners are required to make a policy change or accomplish a partial or total surrender. Distribution checks are payable jointly, for example, to John and Mary Jones. Two 1099 forms are sent, one to each joint owner for one-half of the total distribution.

A parent and a child may not recognize the tax problem with joint ownership. Assume a parent buys an annuity as joint owner with her child, viewing the arrangement as a way to pass property to the child outside probate at the parent’s death. Later, financial events require her to make a partial or total surrender. Although the money is intended for the mother’s use, the child pays tax on one-half the distribution, and if under age 591/2 will pay the 10% penalty tax.

Joint ownership also may cause adverse gift and estate tax consequences. If a party purchases a joint annuity and contributes the entire premium, there’s a taxable gift of one-half of the premium to the other owner. At the first owner’s death, the contact’s entire value will be included in the gross estate unless it’s proved the survivor contributed to the contract. A special rule applies to married couples; one-half of the value is included in the estate of the first owner to die regardless of actual contribution.

A recommendation and a caution: We recommend joint ownership be avoided in most cases; it no longer is effective in the case of parent-child arrangements, nor necessary in the case of married couples.

If the prospect insists on joint ownership, the agent should make sure the contract language is appropriate for joint ownership. Some annuity contracts don’t address the joint ownership issue. On the death of an owner other than the annuitant, the new owner is either the annuitant or beneficiary. The contract should state specifically that the surviving joint owner continues as the contract owner on the other owner’s death.

Non-natural owners: Sometimes the prospect wants the annuity owned by a “non-natural owner,” for example, a corporation or trust. Under IRC Section 72(u), the contract loses its tax deferral if it’s owned by a non-natural person. The credited interest is reported as taxable income to the owner each year, which usually is not desirable. On the other hand, an annuity held by a trust as agent for a natural person is considered as owned by a natural person and therefore retains its tax-deferred status.

Ownership by a living trust: A living trust may own a nonqualified annuity, but we don’t recommend it to a married couple. As described above, if one spouse is the annuity owner and the other spouse the beneficiary, the beneficiary spouse may continue to defer taxation of the credited interest upon the owner spouse’s death. If the policy is owned by a living trust, immediate taxation of the interest or other earnings usually can’t be avoided.

Ownership by a minor: Often, a parent or grandparent wants to purchase an annuity for a child’s education with the minor child as owner. The transaction must accord with the applicable stat’s Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). An adult custodian is chosen; the ownership designation is “Emily Dickinson, custodian for Tommy Jones under the Alabama Uniform Transfers to Minors Act.” Although the owner is an adult custodian, the child’s Social Security number is used. The annuitant is the child and the beneficiary is the child’s estate.

Contingent ownership: The selection of a contingent owner is important if the owner is not the annuitant. The death of an annuitant causes the immediate maturity of the contract. The annuity ceases to exist; all that is left is the death proceeds payable to the beneficiary. Conversely, when the owner dies but the annuitant still lives, the contract continues, but with a new owner. If an owner dies before the annuity starting date, IRC Section 72(s) requires the contract be distributed within five years. This five-year distribution rule doesn’t apply if the spouse is the new owner.

The policy language should be read carefully regarding the contingent owner. Some annuities allow a contingent owner and provide, in the absence of a contingent owner designation, that the new owner will be the deceased owner’s estate. Other contracts provide that either the annuitant or designated beneficiary becomes the new owner on the owner’s death. A few policies name two beneficiaries- a beneficiary who succeeds to ownership in case of death of the owner before the annuitant, and a second beneficiary who receives the death proceeds upon the annuitant’s death.

Selecting an annuitant: The annuitant is the person who receives annuity benefits at the contract maturity date. The annuitant must be a natural person as her life measures the benefits under the contract. The maturity date or annuity starting date usually accords with the annuitant’s age, for example, the annuitant’s 85th birthday. Upon the annuitant’s death, the contract matures automatically and the cash value is paid to the designated beneficiary.

The annuitant almost always should be the same person as the owner. Naming an annuitant other than the owner exposes the owner to two risks: first, the annuitant may predecease the owner, which causes contract maturity and distribution of cash value to the named beneficiary; second, the annuity benefits will be paid to the annuitant, not the owner, on the annuity starting date. Few companies accept joint annuitants. In any event, there’s no reason to use this designation. Naming an annuitant other than the owner is justified only if the proposed owner is older than the maximum age permitted by the insurance company, say, more than 75 years old. If the proposed wants to own an annuity, he or she must name some younger annuitant, such as a child.

Selecting a beneficiary: The beneficiary is the person who receives the annuity proceeds upon the annuitant’s death. The beneficiary election usually is straightforward, without the problems associated with the ownership or annuitant designation. With married couples, the surviving spouse almost always is the beneficiary. As explained above, this designation enables the surviving spouse to continue the contract after the owner’s death.

Minor child as beneficiary: Sometimes, an annuity owner wants to name a minor child as beneficiary. An insurance company will not pay a death benefit directly to a minor child because of the risk of double liability. The policy owner may name a guardian for the child’s benefit in his or her will if annuity proceeds are received by the child while a minor. Absent such will provision, the probate or county court must appoint a guardian of the minor’s property before the insurance company will pay a death benefit.

In the aftermath of a divorce, a policy owner often is concerned the ex-spouse custodial parent will get his or her hands on a child’s funds. A solution, if it’s available in the minor’s home state, is a transfer under the Uniform Transfer to Minors Act. The policy owner names the beneficiary as follows: “Keith Thompson, provided, however, if any proceeds become payable to the beneficiary when he is a minor as defined in the Alabama Uniform Transfers to Minors Act, such proceeds shall be paid to Emily Dickinson as custodian for such beneficiary under the Alabama Act.” Absent the availability of the Uniform Act, the annuity owner creates and names a regular trust as beneficiary, for complete assurance that the ex-spouse custodial parent doesn’t get at the money.

Living trust as the beneficiary: Annuity prospects may request a living trust be the beneficiary. They reason the surviving spouse controls the trust and, therefore, the spousal beneficiary rule applies.

We don’t agree. The trust is not a spouse, and the annuity must be distributed when the annuitant dies. To allow the surviving spouse the choice of taking the money or keeping the annuity intact, name the spouse the primary beneficiary and the living trust the contingent beneficiary. Here are some suggested arrangements for common sales situations:

Printed with permission of Advanced Underwriting Consultants

Last Updated: 12/15/2002 11:53:00 AM