Planning for your own financial future often overlaps with the plans you have for your loved ones. With their security and stability in mind, how can you protect your money and prepare for everything that’s yet to come?
Deciding how you’ll distribute or transfer your wealth after your death requires careful consideration and a thorough understanding of annuities vs. trusts. Here you’ll learn about the purposes and features of each and why you might choose one over the other.
What Is an Annuity?
Annuities are contracted savings products offered by insurance companies to help consumers set up a steady source of retirement income. You can fund an annuity with a contract that allows you to receive regular payments, which may occur a few months or years in the future.
Annuities can have up to four parties:
- The insurance company that issues and manages the contract.
- The owner, who purchases and funds the contract. The annuity owner also names secondary parties, including the annuitant(s) and any beneficiaries.
- The annuitant is the person whose information is used to calculate payment amounts and other contract terms. The owner and annuitant can be the same person, and may or may not be the person receiving payments.
- The beneficiary(ies) is the party named by the owner to receive the accumulating principal, or unpaid payments remaining when the annuitant dies.
Types of Deferred Annuities
There are three main types of annuities:
- Fixed annuities offer a set interest rate, guaranteeing a specific rate of return for at least a portion of the contracted accumulation period.
- Variable annuities offer fluctuating growth rates based on the performance of underlying investments and come with the risk of loss.
- Fixed-indexed annuities are benchmarked based on indices like the S&P 500. Your interest rate may rise or fall to reflect the index’s movements, though your annuity will come with a minimum guaranteed interest rate at least equal to zero.
What Is a Trust?
Trusts are also a type of legal contract, this time specifying how an individual or couple wants their assets to be allocated following their death. Those assets might include the contents of your financial accounts, stocks and bonds, real estate, and personal property, such as jewelry or furniture.
Trusts detail who gets which assets as well as how and when those assets can be distributed. For example, you can choose to earmark funds for a grandchild’s college tuition or lock up assets until a beneficiary is a certain age.
There are three parties to every trust:
- The grantor creates the trust and decides what assets will be included, how those assets will be distributed, and who the assets will be distributed to.
- The trustee is tasked with managing the assets and executing the grantor’s wishes.
- The beneficiary is the person (or people) who will receive the assets held in the trust.
People may have overlapping roles in a trust. For instance, the same individual might be named the grantor and trustee or a trustee may also be a beneficiary.
Note: This article is not intended as legal advice. The laws regarding trusts can vary significantly by jurisdiction, and each individual’s situation is unique. For personalized advice or assistance with creating, modifying, or administering a trust, it is important to consult with a qualified attorney who specializes in estate planning or trust law. A lawyer can help ensure that your trust is properly structured and meets all legal requirements specific to your circumstances. Annuity.com is not liable for any actions taken based on the content in this article.
Types of Trusts
There are two main types of trusts:
- Revocable trusts: A revocable trust can be changed at any time. That includes changing beneficiaries, adding or deleting assets, and altering the distribution timeline. Grantors often pull double duty as the trustee to maintain control over the trust and its assets.
- Irrevocable trusts: Irrevocable trusts typically cannot be changed once the contract is signed. There are some exceptions, but any proposed changes must be agreed upon by all trust beneficiaries and there may be a complex legal process involved as well. Because the assets in irrevocable trusts are no longer under the control of the grantor, they’re considered separate property and may be exempt from estate tax and shielded from creditors.
Both revocable and irrevocable trusts can fall into two categories: living trusts and testamentary trusts. Grantors create living trusts before their death as part of the estate planning process. Testamentary trusts are created after a grantor’s death and typically reflect assets and instructions laid out in the grantor’s will.
Annuity vs. Trust: How Do They Impact Inheritance?
Annuities and trusts are both valuable financial tools in their own right. As you build your strategic retirement and estate planning strategy, it’s important to understand the differences and similarities between the two.
Similarities Between Annuities and Trusts
Tax Considerations
Annuities and trusts offer tax advantages you likely wouldn’t get if your child or spouse inherited cash outright. With annuities, one of the main tax benefits is tax-deferred growth. In many cases, you won’t pay taxes until you withdraw funds or receive an automatic distribution from an annuity. Trusts have different tax benefits, acting primarily as a haven for assets you don’t want subject to estate taxes or you want to be protected from long-term care asset liquidation requirements.
Customization
Both annuities and trusts can be personalized to reflect specific needs and wants. Annuities can be tailored according to your preferred risk level, life expectancy, and desired payout structure, though some options may be limited or shaped by the insurer. Trusts are customizable according to what assets you want to include, who will get those assets, and how and when distributions will occur.
Annuities vs. Trusts: Key Differences
Purpose
While annuities and trusts are both worthwhile financial planning tools, they differ in intent. Annuities are typically used to set up reliable retirement income while you’re alive; death benefits may be added to deferred annuities using a rider. Trusts have a wide variety of tax and estate planning purposes but are often focused on handing down assets to beneficiaries when you’re gone.
Management and Structure
Annuities are products sold and managed by insurance companies. You may purchase one for yourself or a loved one. Depending on the type of annuity you choose, you can grow your money over time according to contracted interest rate amounts or based on the performance of an index.
Trusts are legal arrangements designed to oversee, protect, and eventually distribute your assets. The trustee, not a third-party company, manages assets and executes the grantor’s instructions after their death.
Ownership and Control
The person who buys an annuity is the owner. They have limited control over how the premium is invested once the annuity is purchased. Instead, the insurance company handles account administration and day-to-day management of funds as long as payments and interest are credited as contracted.
Trusts offer differing levels of control. A revocable trust is still owned by the grantor who can typically change around assets and trust terms at will. Irrevocable trusts remove asset ownership from the grantor. Instead, the trustee manages assets and oversees any issues, and terms are largely unchangeable.
Taxes
Annuities and trusts are similar in that they offer tax benefits, but each option’s potential taxes are treated differently.
Annuities are generally tax-deferred until you withdraw money or the account annuitizes and starts paying you income. Then, you pay taxes on the interest credited to the account (the growth above your principal amount). However, if you purchased your annuity with pre-tax dollars (in a traditional IRA or 401(k) for example), you may be taxed on the entire amount as ordinary income.
Revocable trusts are still part of the grantor’s estate and may be taxed accordingly upon their death. Irrevocable trusts may be considered as a separate taxpayer. Income from assets, such as rent from rental properties or investment dividends, must be reported under a new tax ID and is subject to IRS tax laws.
Trusts may also be subject to capital gains taxes, gift taxes, estate taxes, and property taxes.
How Are Beneficiaries Generally Taxed?
When the beneficiary of an annuity receives an annuity death benefit, they pay taxes on that money. Qualified annuities are funded with pre-tax dollars, so beneficiaries must be taxed on the entire distribution. Nonqualified annuities are funded using after-tax dollars, so beneficiaries only owe taxes on the growth amount or earnings.
Similarly to how annuity taxes for beneficiaries are structured, taxes for trust beneficiaries are due when assets are distributed. Beneficiaries pay taxes only on interest or other growth-based income, not on distributions from the trust’s principal.
Can an Annuity Be Part of a Trust?
A trust-owned annuity occurs when a trust includes an annuity in the overall collection of assets. When purchasing an annuity within a trust, the insurance provider will require trust documents for verification. The trustee then manages the annuity like any other asset, with annuity value distributed to the contingent annuitant or beneficiary based on the details of the annuity contract.
Because annuity income is based on the annuitant’s life expectancy, the annuitant must be a living person. The trust itself cannot be an annuitant. When you put your annuity in a trust, the trust receives the same benefits as an annuity, including the opportunity for the money to grow tax deferred.
Annuities in a revocable trust may be easier to change, but there’s a lower level of protection in place as well. These annuities may be counted as part of your estate, rather than an asset held in trust for a beneficiary, and could be taxed at a higher rate. Some states exempt annuities from bankruptcy, an exclusion that may still apply even if the annuity is in a revocable trust.
How To Choose Between an Annuity and a Trust
Estate planning can be a complex and very personal journey. Therefore we recommend you consult with a licensed professional throughout your journey. How you choose between an annuity and a trust will depend on factors like your financial goals and personal priorities.
- Goal: You may choose an annuity if your primary focus is guaranteeing retirement income. You may prefer a trust if you’re more interested in organizing, managing, and distributing your assets to beneficiaries.
- Control: Annuities are products purchased from and managed by insurance companies. Your control is limited. A revocable trust offers grantors more control and flexibility. Irrevocable trusts offer customization up front, but not as much ongoing control.
- Taxes: Both annuities and trusts offer tax advantages, but the mechanisms and benefits can differ significantly. It’s best to ask a tax professional which approach to estate planning makes the most sense for your situation.
- Access/Liquidity: If you need money outside contracted annuity distributions or before the account’s surrender period is over, you may incur charges from the insurance company and tax penalties from the IRS. You may have more liquidity with a trust, so you or a beneficiary could withdraw funds for an emergency or other allowable purpose.
No matter which option you choose, planning is important if you want to help your beneficiaries avoid probate court. In addition to ensuring your paperwork is in order, discuss your plans with those who stand to inherit your assets. They should know the implications of inherited annuities (in the case of stretch or legacy annuities), the schedule for distributions, and who is managing the trust.
Personalizing Your Estate Plan and Portfolio
From tax implications to interest rates, and grantors to income guarantees, the details of annuities and trusts are as intricate as they are important. Learning how to manage and protect your assets could be the key to unlocking a stress-free retirement and even providing for the next generation. But it takes time and professional insight to understand which planning tool best suits your needs and how you can make the most of your nest egg.
For more information on how annuities could help you plan for the future, reach out to one of the licensed agents at Annuity.com.
