I am not a tax attorney, nor do I play one on TV.
I am, however, a financial guide who understands the need for thorough, complete estate planning.
In recommending trusts to many of my clients and prospective clients, I have run across situations in which someone wanted to use a trust differently than for typical estate planning purposes.
For example, some people have asked if it is ever a good idea to use an annuity to fund a trust or to move an annuity into an existing trust. In many of these cases, the client wanted to begin funding beneficiaries while he or she was still alive. An annuity seemed to be a reasonable way in which to accomplish this goal.
While this scenario is not unheard of, and in some cases, putting an annuity in a trust can accomplish specific client-specific goals, the right annuity must be paired with the right trust. As you may know, annuities enjoy preferential treatment under US tax law. Internal Revenue Code Section 72 is dedicated solely to annuity products and their treatment concerning taxes.
The favorable rules of IRC Section 72 are designed to further the use of annuities as retirement savings and/or income vehicle. So it makes sense that these laws generally only apply when a living, breathing human being owns an annuity directly.
This is why, when it comes to placing an annuity in a trust, you’ll need to be extremely careful or else risk losing the annuity’s preferential tax treatment.
IRC Section 72 (u) limits this favored treatment when an annuity is deemed not to be held by a “natural person.” When an annuity is owned by a non-natural person, such as an LLC, corporation, or other entity, gains in that contract are taxable income. The exception to this rule is if an annuity is held by a specific type of trust, under certain conditions, where the trust is acting as an “agent for a natural person.”
Unfortunately, as is the case with much of our tax code, there is little to no clarity when it comes to certain definitions. In the case of annuities inside a trust, it’s hard to decipher precisely what is meant by the term “agent for a natural person.” Even the supporting Treasury Regulations offer little insight as to this definition. It has taken a series of Private Letter Rulings (PLR’s) over the years to establish the various kinds of trusts that could potentially own an annuity without compromising its’ tax-deferred status.
For example, PLR’s have determined that some specific kinds of trusts, such as a bypass trust for the benefit of a surviving spouse and/or children, can retain their favored tax status. However, if other beneficiaries are involved in the trust (ex: a charity) that annuity might very lose its’ preferential treatment. The basic rule of thumb is that for a trust to qualify as an agent for a natural person, that trust’s beneficiaries for both the income and the remainder must always be natural persons.
There are a few instances in which placing your annuity in a trust might be beneficial. For example, putting an annuity inside a trust will give you greater assurance of having control over the annuity, even if you are unable to manage it personally.
Another situation involves Individual Retirement Accounts (IRA’s). While an annuity can’t be held as an IRA for tax purposes, you can place an individually-owned annuity into a living trust with your spouse as beneficiary. Doing so means that, should you pass away before your spouse, the annuity’s lump-sum payment within the trust can be rolled over into your spouse’s IRA. Placing that annuity into a living trust allows the annuity to provide payments to your spouse until he or she passes. Remaining amounts can then be passed on to the spouse’s beneficiaries.
If your financial planner has indicated that he or she believes putting an annuity into a trust will be beneficial to you, determine the thought process behind this recommendation and ensure it matches your own goals. You should also take the time to get a second opinion from a qualified tax attorney or CPA.
While there are situations in which trusts may own annuities and transfer them in and out, you must understand the details of that particular trust completely. Otherwise, you may wind up making costly mistakes that will cost you thousands in unnecessary taxes.
As with all important decisions always consult a licensed and authorized professional before making a permanent decision.