How Annuities Can Factor Into Trust Management

Understanding Trust-Owned Annuities

Annuities can be an attractive option to many trustees that manage trust assets. Trustees are tasked with administering the trust for the benefit of the trust beneficiaries. This often involves the difficult task of trying to grow and preserve trust assets at the same time, while ensuring that the desired results of the trust document are carried out. It also involves navigating the sometimes-complex rules regarding distributions, income and capital gains of trust assets.

Many of the same reasons that make annuities appealing to individuals also make them desirable inside a trust. Features such as tax deferral, guarantees, risk management, diversified investment options, living benefits, enhanced death benefits, and income control may be especially advantageous to a trustee.¹

Tax deferral

Trust-owned annuity contracts that hold the annuity as an agent for a natural person are generally treated as annuity contracts for income tax purposes and retain their tax deferral (IRC 72u). This is generally applicable if all the trust beneficiaries are natural persons. The attorney that drafts the trust should be able to determine if the trust is acting as an agent for a natural person and qualifies for tax deferral. The trustee generally must certify that election with the issuing annuity company.

Why is tax deferral important?

The undistributed gains inside a deferred annuity are not generally defined as trust income. Accordingly, they do not have to be distributed to current income beneficiaries. This provides trustees with flexibility. They can request distributions only as needed.

Without tax-deferral, trust assets that generate taxable income and taxable capital gains may have undesired consequences.

• Trust income that is not distributed to the trust beneficiaries may be subject to federal income tax up to 37%, and in addition be subject to the 3.8% net investment income tax. Investments that generate income could require the trust pay over 40% in taxes and reduce the effectiveness of the estate plan.²
• On the other hand, if trust income is shifted to the trust beneficiary, the distributions reduce the size of the trust and may create an unwanted tax burden on the income beneficiary. In addition, for irrevocable trusts, passing income to the income beneficiaries moves funds that may be exempt from estate tax back into a potentially taxable estate.
• Short-term capital gains and qualified dividends inside the trust are taxed as ordinary income at the trust tax rate. Long-term capital gains may be taxed up to 20%. Trust rules regarding reporting and distribution of capital gains can be complicated. Payment of capital gains tax by the trust may cause additional taxes on distributions and reduce the value of the trust.

Management and Reporting

Trust assets are reviewed by the trustee and it may be necessary to make modifications. If in the trust beneficiary’s best interest, the trustee may adjust the investment strategies within the annuity, or choose a 1035 exchange to another annuity contract without triggering income or capital gains tax.³

Fiduciary Responsibility and Liability

The trustee has a significant responsibility. He or she is responsible for executing the provisions in the trust document, managing the trust assets, and preparing the necessary reporting and tax filings. The trustee owes a fiduciary duty to the trust beneficiaries and may be personally liable for a breach of that duty. Annuities may help in the following ways:

• The tax-deferral aspect of annuities my help lessen the burden of taxes, management, and reporting as described above.
• The guaranteed features and income provisions of annuities may help ensure that the required income distributions outlined in the trust are met.
• Certain annuities, such as Fixed Indexed Annuities and Registered Indexed Linked Annuities, may offer a unique combination of growth potential with limits on downside loss. This may help with diversification and minimizing risk to be in compliance with modern portfolio theory and applicable laws.

Special Annuity Features

Annuity product riders and contract provisions may be very useful in a trust owned situation.

• Guaranteed Lifetime Withdrawal Benefit: May be utilized to provide guaranteed income payments to the trust beneficiaries if applicable and in accordance with the trust document.
• Enhanced Death Benefit: Provides steady, predictable growth towards the annuity death benefit. May be applicable in trusts where the beneficiaries do not receive a payout until the death of the grantor/annuitant.

Considerations and Limitations

Annuities may not be appropriate in all trust situations. Some of the issues to consider are:

• For a trust-owned annuity the death benefit gets paid at the death of the annuitant and not the death of the Grantor. Choosing the right annuitant and product should match up with the provisions in the trust document.
• Most issuing annuity companies require the trust to be the annuity beneficiary. The death benefit is paid to the trustee and distributions are paid according to the trust document. The balance of the annuity must be paid out within five years of the annuitant’s date of death.
• Generally, the annuitant’s spouse can not continue the contract upon the annuitant’s death.
• A non-qualified stretch is not available.
• Pre-59 1/2 distribution penalties for trust-owned annuities may be based on the age of the annuitant.
• When an annuity is transferred by the grantor to their grantor trust (whether revocable or irrevocable), the annuity is not considered “transferred” for income, estate, or gift tax purposes.
• Other transfers of ownership may trigger recognition of all gain on the contract at the time of the transfer.

Whether a non-qualified annuity is appropriate to be owned by a particular trust is not a simple question. Please consider consulting with your estate planning attorney, tax professional, and a financial advisor professional regarding the suitability or if of an annuity in a trust is in the best interest.