A principal goal of many estate plans is to provide incometo the estate owner’s heirs. This goal can often be achieved by using either immediate or deferred annuities. Where the goal is to provide heirs with an immediateincome, an immediate annuity may be the ideal mechanism, especially if the income is to continue for the recipient’s lifetime. The certainty afforded by such a contract is sometimes more important than the amount of each income payment or the fact that the annuity income does not preserve principal. This may be particularly appropriate to satisfy specific beneficiary lifetime income bequests from a portion of assets while the remainder passes to another beneficiary.
2. Purchase of an immediate annuity for heirs outside a trust
Sometimes, an estate owner’s goals include providing a specific and certainincome for specified heirs, apart from the overall dispositive provisions of the estate plan. Here, an immediate annuity is arguably the perfect instrument. Without the certainty of the annuity, a trustee or executor must take into account the market risk involved when invested assets must be accessed each year to make payments to the beneficiary. Thus, the use of an annuity may allow the trustee/executor to invest more money immediately on behalf of the other beneficiaries while still guaranteeing that the income beneficiary will receive all promised payments.
3. Purchase of a deferred annuity for heirs
Where estate planning goals include providing a certainincome for heirs to begin at some future time, a deferred annuity may make sense. Advantages include tax deferral of current gains, which can be of considerable importance if the annuity is owned by a trust subject to the compressed tax rates applicable to nongrantor trusts, creditor protection (to the extent allowed by relevant law) where the annuity is owned outside a trust, and the risk management and investment characteristics of deferred annuities discussed at length in earlier chapters of this book. Disadvantages include the overhead cost of the annuity, which may be higher than that of alternative investments, surrender charges (if applicable), the fact that all distributions from an annuity are taxed at ordinary income rates, and the unavailability of a step-up in basis for annuities owned by a decedent.
5. Using a variable deferred annuity to provide death benefit to an uninsurable estate owner
A deferred annuity is not life insurance. A contract qualifying as life insurance under Section 7702 of the Internal Revenue Code has a death benefit that is taxed differently (under Section 101) from a contract qualifying as an annuity under Section 72. The two chief differences are:
- All gain, or excess of contract value over adjusted basis, in an annuity will be taxed as Ordinary Income, either to the living contract holder or to the beneficiary. By contrast, the death benefit of a life insurance policy is generally received income tax free by the beneficiary.
- Distributions to the living owner of a life insurance policy are generally taxed under a first in, first out basis. All distributions are considered a return of principal until all contract gain has been distributed. Distributions from an annuity (issued since 8/13/82) are taxed on a last in, first out basis, or as gain until all gain has been distributed. This same treatment also applies to life insurance policies that are modified endowment contracts.
That said, a variabledeferred annuity often provides a death benefit in excess of the contract’s cash value, whereas the death benefit of most fixeddeferred annuities is limited to the cash value. The advantage of this additional death benefit in a variable annuity can be significant, especially for an individual who cannot obtain life insurance, or for whom the rates would be unacceptably high. This is for one simple reason: while the contract owner does not escape taxation on that death benefit, he or she does escape insurance underwriting. The annuity death benefit is available to anyone who is willing to pay the standard cost charged for it.
6. Using the guarantees in a deferred annuity to provide portfolio insurance
A fixeddeferred annuity provides three guarantees to its owner:
- A guarantee of principal. The money invested in a fixed deferred annuity is guaranteed against loss by the insurer.
- A guaranteed minimumrate of return.
- Guaranteed annuity payout factors.
The first two guarantees provide a known minimum return, on the portion of one’s portfolio allocated to the annuity, which has the effect of lowering the overall principal and interest rate risks of the entire portfolio. Moreover, the assurance that this known future value can be converted into an income stream that will provide at least a certain amount of money each year can make projections of one’s future cash flows less problematic.
7. Using the guaranteed income of an immediate annuity to reduce retirement portfolio failure rate
As noted, the risk managementbenefits of either a fixed or variable deferred annuity may allow some clients to invest their retirement portfolios — the portion invested in those annuities, but also, perhaps, more of the nonannuity portion — more aggressively, and with more confidence, than they might in the absence of these guarantees. The result of such a change in allocation should, over time, be an increase in the income produced, despite the expenses of the annuity. For retirees living on less than the amount their portfolios earn, this translates to greater capital accumulation, ultimately providing more wealth to transfer to heirs.
8. Using annuities to maintain tax deferral, and control, from beyond the grave
Ensuring tax deferral of gain beyond the annuity owner’s lifetime
The income tax on annual gain in a deferred annuity is generally deferred until it is distributed. Distributees of annuity proceeds can benefit from even further tax deferral if those distributions are considered amounts received as an annuity. If so, a portion of each payment is excluded from tax as a return of principal under the regular annuity rules of IRC Section 72(b). This treatment applies to annuity payments whether made to an annuitant or to a beneficiary. Thus, if a deferred annuity is structured so as to ensure that the beneficiary or beneficiaries can, or perhaps must, take proceeds in the form of an annuity, the benefits of tax deferral will survive the annuity owner. This can be done utilizing a concept known as the stretch annuity.
9. Using a SPIA to provide for a longtime household employee
Often, wealthy clients wish to provide benefits, at their deaths, to longtime household help. They may be concerned that the employee might lack the skills to manage a lump sum bequest, or might squander it. A direction, in the estate planning documents, to purchase an immediate annuity for the benefit of that employee can address these concerns, without the hassle of establishing a standalone subtrust for such purposes. A SPIA would ensure an income for that employee for lifetime; moreover, the cost of a life-contingent immediate annuity for a specified amount of income decreases with the age of the annuitant at issue. Thus, the longer the estate owner lives, the older the employee will be when the annuity is purchased, and the lower the cost of the annuity.
10. Using a SPIA to fund a small bequest
Similarly, a SPIA might be used to fund a small bequest to someone not a beneficiary under the client’s trusts, where there is concern that the recipient might be unable or unwilling to manage the bequest prudently and where the amount of the bequest is less than the minimum that professional trust managers will accept. Of course, this assumes that the SPIA bequest itself would still produce a large enough monthly or annual payment to be a meaningful bequest in the eyes of the decedent.
12. Using a deferred annuity to fund a QTIP trust
In some estate planning situations involving trusts, the use of an annuity may be problematic. Gary Underwood writes:
“Annuities may not be appropriate investments for QTIP trusts for a reason associated with state law definitions of income. In most states, the undistributed gains inside of an annuity are not defined as income, and therefore may not have to be distributed to the income beneficiary. Income would only be recognized to the extent the trustee made withdrawals of gains from the annuity. If the trustee made no withdrawals, then there may be significantly less trust income to distribute to the surviving spouse. The trustee could be placed in an unenviable position between the surviving spouse who may want to maximize income and the children who want to maximize principal for later distribution. Unless the trustee and all beneficiaries agree on specific parameters for any annuity withdrawals, an annuity may present problems.”
13. Using a variable annuity to fund a charitable remainder unitrust
One commonly used application of a variable annuity is in funding a charitable remainder unitrust (CRUT). In fact, the variable annuity has often been touted as the perfect funding instrument for the so-called spigot NIMCRUT — especially by those marketing variable annuities. Is it? The following discussion will examine the pros and cons of such a strategy. But first, some terms need to be defined. What is a spigot NIMCRUT?
A CRUT is a type of Charitable Remainder Trust (CRT) — a split-interest trust with a charitable remainder beneficiary and one or more noncharitable beneficiaries with rights to payments each year during the term of the trust. Often, the estate-owner client is the noncharitable beneficiary. The CRUT provides that the noncharitable beneficiaries will receive a unitrust amount each year (i.e., a certain percentageof the trust value, as revalued each year). CRTs that pay specified amounts each year are called Charitable Remainder Annuity Trusts.