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Common Annuity Planning Mistakes

Knowing what they are and how to avoid them will help keep you and your client out of trouble.

By Ayo Mseka

Annuities are powerful financial-planning tools that can be used to solve many client needs—and they enjoy a tax-favored status in the Internal Revenue Code. But the rules governing them can be complicated, and if you and your client are not careful, you can trip over some of the more technical aspects.

During the Securities America Conference held recently in Salt Lake City, Joshua Anton, CFP, CPE, PACE, CLU, ChFC, an advanced variable annuity specialist with Lincoln Financial Distributors, described some common mistakes planners make when dealing with nonqualified annuities. Here are some of these mistakes—and steps on how to avoid them.

Failing to understand that not all annuities are “tax-equal.” The tax rules governing annuities are contained in Sec. 72 of the Internal Revenue Code and are very specific, Anton said. At various points in time, Congress changed the rules governing how annuities are taxed; therefore, not all of them are created equal in the eyes of the IRC. Some important examples are:

a. Failing to capture the annuity issue date when fact-finding. “Be sure to capture the issue date because one day’s difference can make a big difference for your clients and the IRS,” he stressed.

b. Not understanding the difference between the last in, first out and the first in, first out taxation treatment of annuities. Withdrawals from pre-August 14, 1982, annuities get the FIFO method, while post August 13, 1982, annuities receive the LIFO method. The gift of an annuity issued after April 22, 1987, results in the policy owner being taxed on the gain, but this is not true for annuities bought before April 22, 1987.

Forgetting the basic rules of Sec. 1035 exchanges. Section 1035 of the IRC contains rules for effectuating a so-called tax-deferred exchange of life, annuity and endowment contracts. You must familiarize yourself with these rules because if you make a mistake, “the consequences for your client can be severe,” Anton said.

Forgetting that life insurance, endowment and annuity contract exchanges are made “down the chain.” Changing contracts should not be a realization event. “You can’t exchange up the chain, only down,” he said.

Multiple 1035 exchanges. You can exchange one annuity for more than one annuity—the IRS has privately ruled that single-to-multiple 1035 annuity exchanges are permissible. You can also exchange more than one annuity for one annuity. Multiple-to-single 1035 annuity exchanges are permissible, but they must be “like for like.”

A good question to ask is whether the deferred buildup of cash values inside a client’s annuity causes his Social Security payments to be exposed to income tax.

Making minors owners and/or beneficiaries of annuities. The problem with this mistake is that minors don’t have the legal capacity to execute a contract. They can’t execute policy-ownership rights and can’t annuitize and make withdrawals. The solution is to make sure that all the kids and grandkids of your client are over the age of majority. And, he said, you should know when to use an UTMA or an UGMA.

Assigning or pledging an annuity. This can result in adverse tax consequences for the owner. Sec. 72(e) of the IRC has a special rule that deals with the pledge or assignment of an annuity. Any portion of an annuity that is assigned or pledged is treated like a cash withdrawal to the extent that the cash value without regard to surrender charges exceeds the investment in the contract.

What happens if you gift a deferred annuity? If the annuity was issued after April 22, 1987, the excess of the cash surrender value over the premiums paid is taxable per IRC Sec. 72(e) (4) (c). There are a couple of important exceptions, however. These are transfers between spouses and transfers between former spouses incident to a divorce.

How are corporate-owned annuities taxed?A flag should go up when anyone mentions an annuity being owned by a “non-natural” person, Anton said. In 1986, Congress changed the rules governing deferred cash value buildup and annuities. Essentially, annuities owned by non-natural entities such as corporations and limited liability corporations and partnership-owned annuities lose their tax-deferred buildup.

Failing to understand the creditor-protection advantages of annuities. Creditor exposure is a concern for many wealthy clients. The bottom line is that annuities can be strong asset-protection vehicles in some states. Many states have a statute that deals with how much, if any, an annuity is exempt from the claims of creditors and in a bankruptcy, including annuity cash value and annuity income. In a few states, the exemption is unlimited while other states put a cap on the exemption, which can be very low. You need to check with the attorneys in your state.

Forgetting the rules governing gifts of annuities to charities. If an annuity contract is gifted to a charity, then the client must pay income tax on the gain. The client may be able to take a deduction for the full value of the annuity, but only after paying income tax on the gain.

Annuities and Social Security benefits. A good question to ask is if the deferred buildup of cash values inside a client’s annuity causes his Social Security payments to be exposed to income tax, Anton noted. According to the IRC, the buildup of annuity cash values is not counted when calculating a taxpayer’s modified adjusted gross income but tax-exempt municipal bond interest is counted in the MAGI.



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