The wrong selection of the owner, annuitant, or beneficiary of an annuity can thwart a client's planning objectives in many ways. Bad decisions regarding annuity designations are usually the result of either failing to carefully read the contract or relying on faulty information, such as your best friend telling you that annuities should be owned by trusts to avoid probate, and she should know since her ex-husband's second cousin used to work for an attorney. The best way to ensure that you make good decisions regarding annuity designations is really pretty simple -- assume nothing and verify everything.
Following are nine common assumptions that agents often make that can lead to trouble.
1. Naming a spouse as beneficiary guarantees continuation of the contract. The Internal Revenue Code generally permits a surviving spouse to continue a deferred annuity contract owned by their deceased spouse so long as they are the designated beneficiary of the contract. The surviving spouse becomes the new owner, and the contract continues tax-deferred until the surviving spouse dies or reaches their annuity start date. Some contracts, though, restrict this provision. For example, a contract may require that the surviving spouse be the sole primary beneficiary. If other primary beneficiaries are named, spousal continuation is not available. Other contracts may allow the surviving spouse and children to be primary beneficiaries but limit spousal continuation only to the extent of the surviving spouse's remaining portion of the contract.
2. If a grantor trust is the owner and the grantor's spouse is the beneficiary of the contract, the spouse can continue the contract upon the grantor's death. Depending upon the terms of the annuity contract, spousal continuation may not be available if a trust is the owner of an annuity.
3. If a grantor trust is the owner and the grantor's child is the beneficiary of the contract, the child can take distributions over their life expectancy upon the grantor's death. As described in the second example, many annuities will make the owner-trust the designated beneficiary upon the death of an annuitant. This designation of the trust as beneficiary may preclude the grantor's children from being able to receive the remaining value of the annuity over their life expectancy. The only distribution option available to a trust that owns such an annuity is either a lump sum distribution or payment of the annuity value within five years. Distributions to the child will depend upon the terms of the trust.
4. A contract will continue upon the death of a joint owner. An annuity contract must require that the insurance company begin distributions upon the death of any owner unless the designated beneficiary is the surviving spouse. If there is more than one owner, the death of any owner will trigger this requirement. Therefore, naming a joint owner won't help your contract stay in force longer, but it may help it end sooner than you thought. Note: If a contract states that upon the death of an owner, a joint owner automatically becomes the designated beneficiary and the joint owner happens to be the surviving spouse, then the surviving spouse can continue the contract even if they were not listed as a beneficiary.
5. The death of an annuitant will trigger distribution of a contract. As previously stated, while an annuity contract must begin distributions when an owner dies if the beneficiary is not the surviving spouse, most contracts do not require that there be a distribution of the contract upon the death of an annuitant. There is an exception, however: When a trust or other entity owns the contract, distributions must begin when the primary annuitant dies or is changed.
6. "Payee" and "beneficiary" mean the same thing. There is a distinction between a beneficiary and a payee. The payee is the person who is designated to receive payments after annuitization. A payee's rights end when the owner dies. A beneficiary receives the death benefits under the annuity payable if the owner dies before the annuity matures. The beneficiary also receives any remaining annuity payments, such as those payable under a period certain provision or refund option, upon the death of the owner.
7. Gifting ownership of a deferred annuity doesn't have any income tax consequences. The general rule is that the gift of an annuity is taxed to the extent of gain in the contract. Essentially, tax law treats the transfer as a complete surrender followed by a gift of cash. Exceptions to this rule are made for annuities purchased on or before April 22, 1987; transfers between spouses; additions of a spouse as joint owner; transfers due to divorce if required by the divorce decree; transfers from an owner to their grantor trust; transfers from a corporation to an individual; changes due to court order; or changes or additions during the free-look period.
8. By naming an annuitant who is older than 591/2, you can avoid the 10 percent federal penalty tax on early withdrawals. In general, a 10 percent federal penalty is applied to the taxable portion of any withdrawal from a deferred annuity contract prior to the owner attaining the age of 591/2. The age of an annuitant is irrelevant in determining whether the penalty tax applies. What happens if the owner is a trust? If a trust owns the annuity contract and it does not qualify for another exception to the penalty tax, then it is the age of the grantor (if a "grantor trust") or the age of the trust beneficiary (if a "non-grantor trust") that determines whether the penalty tax applies.
9. If a single premium immediate annuity is used to help fund a non-qualified deferred compensation obligation, the executive should be the owner. Naming the executive as owner of an immediate annuity will likely cause the entire present value of the annuity to be taxable to the executive in year one. This is probably not the result the client was looking for. Nor is it generally a good idea to name the executive as an irrevocable payee under the contract, as this may be considered "constructive receipt" and trigger unwanted tax consequences. Instead, the employer should own the contract and, if they want, use annuity payments to meet their obligation to the executive.
The most important thing to remember is that not all annuity contracts are the same and that most mistakes come from failing to carefully read the contract language. If in doubt as to how to structure designations, it is always smart to get tax or legal advice from a qualified professional.
Barton J. Bradshaw, J.D., is an advanced marketing attorney with Genworth Financial. He can be reached at barton.bradshaw@genworth.com.
