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Sheltering Your Clients’ Nest Egg

Annuities are sound investments, but they must be properly structured to achieve their fullest potential.

By Paul M. League, CFP

Annuities are investment contracts issued and backed by insurance companies and offered as either “Fixed” or “Variable.” Annuities meet two primary goals: either long-term asset growth or “immediate” income. Fixed-rate annuities (FA) offer a fixed rate of return, typically guaranteed for one year and adjusted annually, or more frequently, depending on the timing of deposits or other company-specific criteria (index annuities are a variation of this type). Variable-rate annuities (VA) are a more modern type of annuity, offering investors a variety of investment options (similar to mutual funds) that generate “varying returns.” VA subaccount investment options include conservative money market, fixed income, equities and, in some cases, accounts managed by large institutional money managers otherwise not accessible to the typical investor due to their large minimum investment requirements.

The key feature of annuities lies in their tax deferral. Of the two annuity types mentioned, VAs offer a greater potential for asset growth through investment subaccount options tied to market performance. They are best suited for long-term investors who are not averse to taking risks. VA investments “breathe with the market,” meaning performance rises and falls with changing financial market conditions, with the exact weighting of invested dollars within the VA subaccounts depending upon individual risk tolerance and investment objectives.

For the long haul
Annuities are not short-term investments (like bank CDs) and impose penalties for early surrender or distribution, namely:

  1. Insurer product penalties, contingent deferred-sales charges (CDSC), usually decline over a 1- to 15-year period. However, some offer a no-surrender penalty feature.
  2. IRS-imposed penalties equal to 10 percent on “premature withdrawals/distributions,” - i.e., those prior to age 59-1/2 years.

Of these two penalty sources, only the 10 percent IRS penalty can be avoided under IRC Code Section 72(q) - and for qualified plans Code 72(t). This is done by taking equal distributions over a period of time not less than 5 years in duration and so long as that period of time takes one to the age of 59-1/2. This IRS penalty is meant to prevent premature distributions and is understood as a kind of “balancing mechanism.” The intent of the laws that allow for annuity tax deferral is to encourage the public to invest for their futures - rather than overly depending on Social Security or other government programs - in return for the compounding advantages of tax deferral.

Annuities are generally not suitable as estate-planning vehicles; instead, they are used for meeting living and retirement-income needs. An exception is charitable annuities through charitable remainder trusts (CRTs), where one transfers highly appreciated assets out of an estate to a charity to reduce capital gains taxes. The charitable remainder trust holds or sells assets until the death of the last income beneficiary, with the remaining assets going to the charity. During the lives of trust-income beneficiaries, the annuity income provides the donor with an income that will often be used to purchase life insurance, in a separate life insurance trust (not part of the charity), to create or expand an estate upon the death of a donor on an income-tax-free basis.

Many use the annuity as a kind of in-life “cash bucket” to fulfill needs like education costs, mortgage down payments, and retirement income. So, despite penalties, annuities have many liquidity features. Yes, when assets are taken prior to age 59-1/2, there is that potential 10 percent penalty (except in cases of disability, or on earnings on an investment made before August 14, 1982, or as a part of a series of substantially equal periodic payments (SEPP) for life and not modified before age 59-1/2, or within 60 months if modified after age 59-1/2, or on payments made to a beneficiary or the annuitant’s estate). But many feel the benefits of tax deferral far outweigh these concerns. It is important to note that withdrawals on investments made into annuities issued after August 13, 1982, are treated as income first, according to Last In, First Out (LIFO) - Last In being gains/interest, First Out being taxable as income.

Protected savings
Annuities can also be used to fund tax-deductible traditional IRA accounts, making deposits not only tax-deferred but also tax-deductible. While there has been some controversy over using an annuity in an IRA (since each provides tax-deferral), or using them over a mutual fund outside an IRA, the National Association for Variable Annuities (NAVA) outlines many benefits in doing so anyway.

These include:

“Variable annuities offer a variety of features that distinguish them from mutual funds. One of the most valuable is the array of payout options tailored to the needs of the contract holder, including the right to annuitize the accumulated value over a lifetime or a specified time period. Some other features: a death benefit that bypasses probate and often protects beneficiaries against market downturns prior to annuitization; the same tax deferral that you get with a pension plan, but without the contribution limitations; the ability to transfer among funding options without creating a taxable event for the investor; and a one-stop shopping approach that combines fixed-income and stock/bond investment options in one account.” (Letter to editor, AARP Modern Maturity Magazine, March 1994

Another advantage offered in some annuities can be found in bonus products that provide investors with immediate credits of a percentage of purchase payments. However, there are often additional hidden charges that one must carefully evaluate when considering such product features.

What about the effect of taxes on mutual funds versus annuities? The “time factor” seems to erode any perceived advantages of mutual fund investments since one has to pay ordinary income taxes on short-term capital gains, interest and dividends - and only slightly reduced taxes on long-term capital gains. Taxes can vary to a greater or lesser degree, depending upon the “tax efficiency” of any given mutual fund, but with annuities, all appreciation is deferred and subsequently paid out under a more favorable exclusion ratio. This is a formula that recognizes that part of any annuity annuitization distribution is really a return of principal and is therefore nontaxable. However, less than 10 percent of annuity contracts are ever annuitized; as a result, few take advantage of this exclusion, leaving most distributions in the form of death benefits or withdrawals (taxed as income first).

Deferring the taxes
The more aggressive growth mutual funds (i.e., small cap, sector, international equity funds) are not, by their nature, “tax efficient,“ and therefore spin off more taxes than conservative income-styled funds (i.e., bond and government securities funds), all things being equal. This makes a stronger case for transferring especially aggressively invested mutual fund assets into a VA, where investments grow and compound is tax-deferred. Of no small importance is the ability to also freely switch subaccounts within a VA without incurring any income tax. On the other hand, liquidations of mutual funds, due to a change in one’s personal circumstances or markets, cause immediate taxation—making them far less flexible than a VA. While it is true that mutual funds offer free switching within funds of the same family, they do not avoid these taxes. Also, unlike taxable or “tax-free income” coming from a mutual fund, neither the dividends nor the capital gains accumulating within the subaccounts of a VA count in the determination of whether or not Social Security income will be taxed-not so for mutual funds. Regardless of how VA income is earned, it comes out in the form of “ordinary income.”

Any perceived advantage in a mutual fund’s “step-up-in-basis” (the cost basis increased to the fair market value, following death), especially in a changing taxing climate, is of questionable merit. This is largely due to the taxes one has to pay on mutual funds along the way, as well as the loss of compounding appreciation on those assets, had they not been taxed in the first place. Those annuities issued prior to October 21, 1979, also benefit by a step-up-in-basis (if they are ever “1035 exchanged;” however, they then lose this advantage). This would become even less of an issue were we to see an end to the estate tax, better known as the “death tax,” and the hoped-for end of taxes on productivity (income) in favor of a tax system based only on consumption (a retail sales tax). Potential upcoming tax reforms may bring about the end of the present “step-up-in-basis” advantage of mutual funds and stocks, thereby making annuities even more desirable from a tax standpoint.

Some contracts also offer death-benefit protection features equal to the greater of the annuity value, or the greater of 5 percent compounded annually or the largest annuity value on any policy anniversary date prior to the owner’s death or his 81st birthday—whichever is earlier, less any adjusted withdrawals. Often, an owner/ annuitant must be under the age of 80 and must elect this enhancement at the time of purchase. Typical costs for these enhanced benefits are .15 basis points added to mortality and expense charges (M & E), based on asset value, and together total between 1.25 percent to 1.40 percent.

Many investments are skewed to the rich, but annuities are suitable for nearly everyone, and when purchased as a nonqualified investment, also give the purchaser the freedom to continue the tax-deferral advantage to and beyond the age 70-1/2 mandatory-withdrawal barrier of traditional IRAs and qualified plans. As Marilyn Wayne, president of ClienTell, Inc., a continuing education provider based in Torrance, Calif., notes: “Essentially, there are three guarantees in life: death, taxes and annuities. Out of the three, my choice would be annuities. Annuities allow triple compounding upon principal, upon the growth of that principal, and upon the money not paid in taxes. These three
benefits are available through tax-deferral, a powerful savings and retirement benefit for any investor.”

Proper annuity structuring considerations
All deferred annuities come in two contract “forms”: namely, as Owner-Driven (OD) and Annuitant-Driven (AD). By “driven,” we mean that certain actions forcibly occur upon death that are beyond the control of named parties to the contract, unless proper structuring is done regarding who owns, who is an annuitant and who is a beneficiary to the contract. These structuring issues must be understood and addressed before anyone invests in an annuity. To begin with, one must first understand the type and then proceed cautiously from there:

  • Owner-Driven Owner(s) have all legal rights, and can change, as needed, the designated annuitant, as the contract specifies, without any negative tax or penalties. OD pays out only on death of the owner.
  • Annuitant-Driven contracts dictate owner(s) can usually be changed and are contract-specific as to whether or not an annuitant can be changed once the contract is issued and, upon the death of either owner(s) or annuitant(s), the contract will pay out.

In either form of contract, changes to beneficiaries (primary or contingent), may always be made.

Before proceeding further, we must also understand two important rules that directly impact proper annuity contract structuring surrounding the event of death:

1. Death of the Holder Rule states that, upon the death of a “Holder” (synonymous with the “taxpayer/owner” in any contract, or, in the case of a non-natural trust-owner, the annuitant is considered the “owner,” but only for death distributions), death benefits of the annuity must and will be paid out (this was enacted by the IRS on contracts issued after January 18, 1985, to prevent generational tax skipping, and later became applicable to “any holder” after April 22, 1987).

2. Spousal Continuation Rule (IRC 72(s)) states that a surviving spouse of a deceased owner has the option of becoming the contract owner and can then continue the contract throughout his or her life and is therefore not forced to take a distribution. (Note that not all insurance annuity contracts offer this spousal continuation provision.) If anyone else is named as a primary beneficiary along with the spouse, the option of becoming the continuing contract owner is usually lost. In cases where a child and spouse are both named as “primary beneficiaries,” some companies will allow spousal continuation on the spouse’s remaining portion of the contract. The IRC states only that the beneficiary be a spouse. However, some contracts specify that the spousal election letter will only be sent out if the surviving spouse is the sole beneficiary—which is a narrower interpretation of IRC.

The enhanced death benefit
“Death Benefits” can come in two forms: the assets that have accumulated in the annuity investment itself or, if the policy offers this feature and it is purchased, enhanced death benefits, which may give an even greater payout based on certain contract guarantees noted earlier. The enhanced death benefits feature is another advantage over many other types of investments. However, a key to death benefit payouts in these two policy forms is to know on whose life the “enhanced benefits” are actually based: is it the owner or the annuitant that triggers the “enhancement?”

In an OD contract, death benefits are based upon the death of the owner (i.e., “owner-driven”). But in AD contracts, death benefits are instead based upon the annuitant (i.e., “annuitant-driven”). In the case of AD contract forms, distributions will occur on the owner’s death as distributions of annuity assets and on the annuitant’s death as death benefits—enhanced or not—when either the owner or the annuitant dies. This could bring about adverse income tax, gift tax and premature distribution penalties to other named parties in the annuity contract. (Please see the examples in this article.)

Yet another adverse outcome can occur when spouses have improper designation as beneficiaries. Special flexibility regarding death benefits exists for spouses of owner(s) in the “Spousal Continuation Rule” noted earlier. This rule gives a surviving spouse (of a deceased owner only) the right to continue to build a tax- deferred asset for heirs. The surviving spouse is therefore not forced to take any assets until he or she desires. This rule is thus a meaningful exception to the “Death of the Holder Rule,” noted earlier. Problems can and do arise when one names multiple “primary” beneficiaries or primary beneficiaries other than solely a spouse.

Implications
Why is any of this of interest or importance to either investors or advisors? Well, in the typical husband-and-wife annuity investor scenario, spouses generally wish to continue the investment until the second spouse dies in order to pass remaining assets onto their children. Without correct contract structuring, serious problems can occur that can negatively impact the parties to the contract. However, if the contract is structured correctly, one can avoid the four main pitfalls of poor annuity structuring brought about by death:

1. Untimely income taxation
2. Unwanted gift taxes
3. The 10 percent IRS penalty
4. Loss of the spousal right of continuation.

Let’s look at identical structuring examples that use the two different contract forms, Owner-Driven and Annuitant-Driven. These examples will illustrate some of the problems that can be avoided when making owner, annuitant and beneficiary designations. As you will see, proper structuring is of vital importance to the parties of an annuity contract.

Seemingly Simple and Benign,but Problematic Spousal Structure

AD (Annuitant-Driven Contract Form)
Owner Husband
Annuitant Wife (a holder in an AD Contract)
Beneficiary Husband and Wife

In this example, were the wife (annuitant) to die first, the husband becomes the sole beneficiary—but cannot continue the annuity under the “Spousal Continuation Rule” noted earlier because there is no deceased owner-spouse. The only owner is the husband, and he continues to live. As a result, distributions will be forced upon him as the sole remaining and surviving beneficiary upon the death of the wife.

Typical Faulty Family Structure

OD (Owner-Driven Contract Form)
Owner Husband (age 60) and wife (age 50)
Annuitant Wife
Beneficiary Children


AD (Annuitant-Driven Contract Form)
Owner Husband and Wife
Annuitant Wife
Beneficiary Children

Problem 1: In the above example, under the AD contract, if the wife pre-deceases her husband, the children will get the payout. While this may look fine, it’s not, because the surviving husband/owner lives, and therefore it’s the same as having made a lifetime gift to the children (he, after all, “owned” 50 percent of the annuity), which creates adverse gift tax consequences in the year of the death, to the husband. (This is like a reduction to the exemption equivalent.) The children, if under age 59-1/2, are also liable for the 10 percent penalty tax, as well as ordinary income tax on any future income paid out of the contract, because upon the death of the annuitant, any beneficiary becomes the taxpayer, not the owner!

Problem 2: In the AD contract, when the annuitant-wife dies, the surviving owner-spouse is considered to have made a gift to the beneficiaries (the children in these cases) and income taxes are due. Gifts between spouses, however, are not subject to gift or income taxes. In contracts where a non-spousal joint owner dies, the surviving owner still maintains all owner rights over that contract and under the “Death of the Holder Rule,” becomes immediately subject to income taxes on any gain in the contract. (In an AD contract, if there were not joint owners - as in the above example - upon the death of the annuitant-wife, there would be the 10 percent premature withdrawal penalty on the owner-husband if he were under 59-1/2 at the time of the annuitant’s death.)

Problem 3: The children, not the surviving spouse, are now in full control of the assets!

Problem 4: Since a spouse was not made the sole primary beneficiary, the surviving spouse loses the right of continuation as per the Spousal Continuation Rule. Alternatively, in a jointly owned contract between spouses, one could name the beneficiary as “joint survivor owner” and thereby not lose the spousal-continuation option.

Problem 5: Finally, by naming any children as “contingent beneficiaries,” the remaining assets would also avoid probate.

Taking corrective action
Are there remedies or corrective actions that can be taken to fix aberrant annuity structures?

Yes, but it is not an easy row to hoe. If you have an improperly structured AD or OD contract, you may want to consider cashing out of it during a down market, where your principal is very close to your policy value. In this way, there are minimal (if any) tax consequences (non-IRAs). Using substantially equal periodic payment payout options (SEPPs) in the first of the three available methods (annuitization, amortization or minimum distribution), can effectively stretch out payments, thereby lowering any due taxes. Remember, too, that the aforementioned exclusion ratio exclusively applies to payments made under the first of these three methods. This is the annuitization method.

Some advisors may recommend a 1035 exchange of contracts. However, a requirement of the law is that exchanges must be “like-for-like” structuring. Use of the 1035 exchange is generally not advisable on contracts where there was a step-up-in-basis before 1979 (before October 21, 1979), but would be acceptable on contracts entered into before August 14, 1982. This is because these are grandfathered so that withdrawals from these contracts are taxed first as “return-of-basis” and then income: first in/first out. Bearing in mind these contract dates, if you had an AD contract with an undesirable annuitant designation, then you could 1035 exchange it for an OD contract that has the same owner and annuitant designation. After contract issue, you would then be able to correct the structuring of the annuitant since, in an OD contract, the owner can (depending on the specific insurance company’s contract) change a “faulty” annuitant. One can employ other strategies, but clearly the best course is to properly structure the contract from the outset.

When structuring an annuity, always structure it in a manner that can result in the least amount of negative tax and penalties upon payout of the death benefit, and with the maximum amount of flexibility regarding those payouts. There are a maximum of four payout options upon the death of the holder/owner (these are not to be confused with contract-annuitization options):

  1. Lump sum within 60 days of death (insurer contract-specific)
  2. Five-year rule-all - money must be out of the contract at the end of 5 years (Code 72 Rule)
  3. Annuitize over life expectancy but make the decision within one year (insurer contract specific)
  4. Several options under this category including 10-year certain
  5. Spousal continuation of contract over the lifetime of the surviving spouse (Code 72 Rule)

(Death benefits/distributions paid out on the death of the taxpayer/owner result in an exception to the 10 percent pre-age 59-1/2 IRS penalty, but that is not the case on the death of an annuitant. Remember, appreciation to remaining contract assets over the five years is not treated as death benefits. Therefore, net gains are taxable in the year earned, and also subject the taxpayer/beneficiary, if under 59-1/2, to the 10 percent pre-age 59-1/2 IRS tax penalty.)

To achieve the maximum pay-out flexibility in structuring your annuity, always preserve not only the first three annuitization options but most importantly, the fourth one: the spouse’s right of continuation. The best way to do this is to name one or the other spouse as sole beneficiary, or—conversely—in the case of joint ownership of the annuity (as in the first example), the surviving spousal owner. If there are children, they should be named as contingent beneficiaries, since this can also preserve for them the first three of the above annuitization options upon the death of the last surviving spouse.

Preferred Family Structure:

OD (Owner-Driven Contract Form)
Owner Husband
Annuitant Husband
Beneficiary Wife
Contingent Children

AD (Annuitant-Driven Contract Form)
Owner Husband
Annuitant Husband
Beneficiary Wife
Contingent Children

Here, if the wife dies first, the husband simply names new beneficiaries (most likely the children) and thus maintains control over the asset. If the husband dies first, the wife gets the asset and can continue the tax deferral (i.e., she is not forced to take distributions). Further, the children may ultimately receive an even larger asset. Note that under this structure, all of the four negative pitfalls under either an OD or an AD contract are avoided. For some clients, one problem is their objection to making one or another spouse the sole owner. However, it is best to name the older of the spouses as the owner. In AD contracts, both the owner and the annuitant should be the same—based on the reasonable assumption that the older spouse is likely to die sooner. Justification for this is found in Mortality Tables that show for ages 50-85, a same-aged female is likely to live beyond a same-aged male by only about 2 to 4 years. But as the spread in age differences increases, the likelihood of the older spouse dying first is statistically much higher (doubling with a 10-year difference in ages, where the younger spouse is the female). A practical solution for spousal-ownership objections like this is to simply buy two separate contracts, one for each spouse.

Finally, many designate trusts as beneficiaries or even contingent beneficiaries of an annuity. First, there is no need to do this because annuities pass probate free. Second, trusts do not allow for any form of spousal continuation nor lifetime annuitization because they are a “non-natural person.” (See the “Non-Natural Person Rule” that applies to contributions into annuities after February 28, 1986.) Third, trusts limit pay-out options to only the first two options listed earlier. Hence, a 50 percent reduction in payout flexibility, which impedes income tax efficiencies on what otherwise could be stretched out, lesser-taxed, distributions. When making a trust the owner, especially in Revocable Trusts (Living Trusts) where there are spouses, it is important to know if the insurance company issuing the annuity views the trust as either a “natural” or a “non-natural person.” If it views the owner-trust as a trust, it will not allow for spousal continuation; this is another problem with making a trust the owner of an annuity. There are no “look-through provisions” on non-qualified annuities (i.e., wherein they will “look through” the grantor/trustee designation and recognize the spouse and spousal-continuation rights). Look-through provisions apply only to IRS-provided rationale for IRAs/qualified plans when a trust is the beneficiary. When using a trust as any part of an annuity structure, one should proceed very carefully. Agents are well-advised to require and obtain a written letter of instruction from the client’s attorney on exactly how the attorney and the client want the structuring set up under an annuity contract.

Annuities are a sound investment for many consumers but as we have seen in the examples cited in this article, they must be properly structured to achieve their fullest potential.

Disclaimer: Annuities are long-term investment vehicles designed for retirement purposes. Variable annuities are subject to market fluctuation, investment risk and possible loss of principal. Variable annuities are not insured or guaranteed by the FDIC. IRAs and qualified plans already have the tax-deferral feature found in annuities, but for an additional cost, variable annuities can provide other enhanced benefits. These include death benefit protection and the ability to receive a lifetime income. All guarantees rely on the financial strength of the issuing insurer. Annuities involve tax penalty and contingent-deferred sales charges for early withdrawal. The contents of this article are believed to be accurate but they are subject to interpretation. We do not offer or provide tax or legal advice or services. Please consult your own tax and legal authorities for such matters.

© Paul M. League, CFP & LFIS. All Rights Reserved

Paul M. League, CFP, is the Principal of League Financial & Insurance Services, a privately held company located in Beverly Hills, Calif., since 1985. League also operates and is a Registered Representative and Investment Advisor Representative with the Beverly Hills Branch Office of Royal Alliance Associates, Inc., Member NASD/SIPC-a SunAmerica/AIG Company. He can be reached at 310-277-3141 or at Paul@LeagueFinancial.net.

 


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