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Annuities provide a stream of monthly income guaranteed for life and can be a beneficial addition to a retirement plan. However, like with any contract, it’s important to know what you sign up for and the terms you decide on. Here are 13 common mistakes to avoid when getting an annuity.
The following situations are applicable to non-qualified annuities and not intended as tax advice. For tax advice, please see a tax professional
1. Placing an annuity in a living trust to avoid probate.
While the decision to place an annuity within a living trust may be born out of good intentions, the adage “no good deed goes unpunished” holds some truth.
Both the annuity and trust will by design allow assets to bypass probate, giving the trust no advantage over the annuity. Additionally, not structuring the annuity properly may cause other issues.
In the absence of using the trust to control the distribution of assets upon the death based on life events of the beneficiaries, naming the trust as owner may be an invitation to arbitration. The annuity itself not held by a trust will pay out to the beneficiaries upon the death of the owner, and unlike the trust may retain tax deferred growth of assets for the beneficiary’s benefit by electing to receive the death benefit as “stretch” distributions which are based on the beneficiary’s life expectancy. If owned by a trust, the five-year rule will be in effect offering, but five years of extended tax deferred growth.
The reality is that both an annuity and a trust bypass probate, therefore no advantage is gained by naming the trust as the annuity owner. If anything, it may provide the catalyst for disgruntled beneficiaries and arbitration.
2. Not naming the grantor of a living the trust as the annuitant.
Another matter involving trust-owned annuities is the structuring of the annuity. Section 72 (u) of the code dictates that in the event of a non-natural person ownership such as a trust, the life of the annuitant will be looked to for the distribution of death benefit assets prior to annuitization. In other words, the annuity must pay out to the beneficiaries upon the death of the annuitant. The grantor trust rules dictate that upon the death of the trust grantor, the trust assets must be disbursed to the beneficiaries of the trust.
So, the potential issue is not naming the grantor of annuity as the annuitant. If different parties are annuitant and grantor, the annuitant may die, forcing death benefit distributions, and if the grantor dies and is not the annuitant, the trust will require the annuity funds to fulfill distribution of the trust assets. If the annuitant is living, the distribution may be subject to surrender fees, taxes, and possible penalties. Naming the grantor as annuitant of their living trust eliminates the issues of one surviving the other.
3. Not naming the trust as beneficiary of a trust owned annuity.
Too often a trust-owned annuity will list different beneficiaries than those named in the trust. Situations may also arise when the same beneficiary is named in both but with differing percentages. This most often occurs if an existing annuity has been transferred to one’s living trust. Because the annuity is a legal binding contract, the insurance company has the contractual obligation to disburse death benefits to the named beneficiaries of the annuity and do so in the proportions dictated by the contract.
Also, the trustee has a fiduciary responsibility to the beneficiaries of the trust. Should the beneficiaries differ, and the annuity carrier pays to the annuity beneficiaries, the trustee as fiduciary will have no other recourse than to seek legal remedy to make the trust beneficiaries whole. The agent who sold or placed the annuity in the trust, the agency, and the insurance company will more than likely be named in legal action. To avoid issues, always name the trust as the beneficiary of a trust owned annuity.
4. Not naming a beneficiary.
As unusual as it may seem, not naming a beneficiary is one of the most common errors committed by an agent and clients when completing an annuity application. The default beneficiary in this case will become the estate of the deceased owner. By becoming a part of their estate, it will be subject to probate and distributed according to the terms of the deceased’s will or in the absence of the testamentary laws of the state where filed.
5. Not naming contingent beneficiary(s) and failing to regularly review contracts.
It is not uncommon for an annuity to be held for a considerable period of time. With time, life situations change and the parties first chosen as beneficiaries may predecease the annuity owner. Not having a contingent beneficiary when the primary dies may lead to the annuity being included in the owner’s estate. Initially naming contingent beneficiaries and performing an annual revue of existing contracts is recommended.
6. Not recognizing how the annuity carrier treats the first death of spousal joint owners 500
Too often annuities are jointly owned by spouses, all too often this is done thinking that the surviving spouse will continue the contract after the first death. Unfortunately, this is not the case.
The death of an owner of a joint-owner prior to annuitization requires a disbursement of death benefits to the primary beneficiary. In all instances, death of a joint owner prior to annuitization will result in a death benefit. However, different companies will treat this situation differently while still following IRC rules.
Whether or not spousal continuation will be an option to the surviving joint owner will be dependent on the rules and treatment by the various annuity companies. Some carriers do not provide contractual provisions to accommodate spousal continuation. In those instances, the primary beneficiary should be “surviving joint owner.” Not naming the surviving spousal joint owner as the primary beneficiary will very likely disinherit the surviving spouse, with the death benefit proceeds being paid to another beneficiary.
Fortunately, many carriers have taken steps to control — if not eliminate — this potential problem. A very common contractual remedy names the surviving spousal joint owner as the primary beneficiary regardless of any previously named beneficiaries to the contract. In this situation, the surviving spousal joint owner as the recognized primary beneficiary has one of three options: exercise spousal continuation, elect to receive the proceeds as a death benefit, or disclaim to contingent beneficiaries or the estate of the deceased spouse.
To avoid unnecessary consequences, be certain of the contractual terms of the annuity you sell.
7. Eliminating spousal continuation by naming multiple primary beneficiaries.
According to section 72 Internal Revenue Code, the spousal primary beneficiary of their deceased spouse’s nonqualified annuity has the option of continuing the contract without recognizing the distribution of the annuity death benefit, and in doing so, continue tax deferral of the annuity assets. Unfortunately, in haste, the spouse may be listed as one of multiple primary beneficiaries. Naming a surviving spouse as less than a 100% primary beneficiary eliminates the option of spousal continuation. To ensure spousal continuation, always be sure the spouse is a 100% primary beneficiary and all others named as contingent.
8. Not recognizing if an annuity is owner- or annuitant-driven.
An owner-driven contract terminates upon the death of an owner prior to annuitization, whereas an annuitant-driven contract will terminate upon the death of an annuitant. While this may seem simple, it does present a series of potential issues including, but not limited to, disinheritance of a family member, income and gift tax liability, and potential penalties for premature withdrawals.
According to section 72(s) of the Internal Revenue Code, the death of an owner prior to annuitization requires a distribution of the annuity assets to the beneficiary. In the event of this occurring, the owner is relieved of all tax liability and the beneficiary is responsible for income tax on the gain in the contract. All potential penalties based on pre-age 59½ distributions are waived upon the death of the owner. By nature of their structure, all owner-driven annuities are in full accordance with the rules in section 72 (s).
Annuitant-driven contracts are designed to terminate upon the death of the annuitant with annuity death benefits paid to the beneficiary. Dependent on the relationship between the owner annuitant and beneficiary, undesirable results may occur. For example, structuring an annuitant-driven contract with the husband as the owner and the spouse as the annuitant. In the event of the annuitant’s death, the death benefit will be paid to the beneficiary who may or may not be the spousal owner (i.e. a child, grandchild, or stepchild). The death benefit paid to them would be irrevocably theirs and all tax liability will fall to the living owner. Dependent on the amount, along with income tax, there may be the need to file a gift tax return, and since the owner is alive, penalties for pre-59½ distributions will still be valid, and if the owner is under age 59½, will be subject to a 10% penalty on the taxable amount.
When structuring an annuitant-driven contract, it is always recommended that the owner and annuitant be the same individual, avoiding any unnecessary complications upon death.
9. Not recognizing the nuances of a non-natural person (corporation or association) ownership of an annuity.
Too often the nuances of non-natural person ownership of an annuity are only considered when working with a trust. However, other non-natural person entities such as corporation associations and organizations present their own challenges.
Like a trust, which details the powers of the trustee to engage in a transaction, a non-natural person (such as an organization, corporation, or association) must also provide a resolution allowing their respective member to enter into an annuity contract with the carrier, and the annuitant be someone within the organization named by the board. An additional requirement should be the naming of the organization as the primary beneficiary of the annuity.
The biggest consideration is tax deferral. Because the annuity is for the benefit of a non-natural person, tax deferral is not recognized by the IRS and the non-natural person owner has the tax responsibility of reporting the gain as taxable earnings. The carrier provides the annual statement and it is the non-natural person’s responsibility to report the net gain.
10. Using an annuity as loan collateral.
Collateralizing annuities is an accepted practice. However, not all companies will allow for the assignment of their issued annuity contracts. For those contracts that are assignable as collateral, the tax consequence accompanying such a transaction is similar to if the owner took a distribution from the contract. When the assignment has ended, the owner of the annuity would then benefit from a step up in cost basis to the contract.
11. Not knowing annuity aggregation rules.
When placing more than one annuity with the same company in the same calendar year, the taxable portion of a withdrawal is determined by the aggregated values of all annuities placed with that company that year. As of 2011, in the event of multiple 1035 exchanges, any withdrawal within six months of the exchange may cause the 1035 exchange to be disallowed.
12. Gifting of an annuity without consideration of the tax consequences.
Some have the false belief that by gifting an annuity, the tax-deferred portion can transfer to a third party without tax consequence. Gifting an annuity without consideration of the transaction is treated for income tax purposes as a withdrawal. The recipient of the annuity will receive the annuity with a step up in basis and the owner gifting the annuity will be responsible for income tax on the gain as if it were a distribution.
13. Assuming all annuity contracts are the same.
Annuities differ in contract operations, features, and benefits. Oftentimes annuities issued by the same company differ significantly. Not recognizing if a contract is owner- or annuitant-driven, or having command of the contract operations regarding death benefits and beneficiaries, can lead to nothing but trouble for all concerned. Before recommending an annuity, read the contract and if necessary, contact a product specialist for definitive answers to possible situations. Annuities can be very complicated as they are governed by Internal Revenue Code rules, contract law, and state department of insurance rules and regulations.