| March 29 2010
Nonqualified variable and fixed annuities (i.e., annuities purchased with after-tax dollars) require special attention in the estate planning process to assure maximum post-death tax deferral.
First, ownership by a trust during the purchaser’s lifetime should generally be avoided. An annuity will avoid probate if it has a named beneficiary; therefore, there is no need for a trust to own the annuity. Also, the IRS could argue that the premature withdrawal penalty can never be avoided if a trust owns the annuity, since the trust can never attain age 59½.
Also, the owner and the annuitant should nearly always be the same individual; otherwise, the death of the annuitant may trigger a mandatory payout under the contract even though sec. 72(s) requires a payout only upon the death of the owner.
Second, the issues in designating a beneficiary for a nonqualified plan are very similar to those for a qualified retirement plan, since, in both cases, the income constitutes “income in respect of a decedent” which will be taxed to the beneficiary upon receipt. All things being equal, the spouse is generally the best beneficiary, because only a spouse may become the successor owner (similar to a rollover of a qualified retirement plan) and continue the tax deferral. For a non-spouse beneficiary, sec. 72(s) provides that, upon the death of the owner, distributions must be made either (i) in full within five years after the death of the owner, or (ii) over the life expectancy of the beneficiary, beginning no later than one year after the owner’s death. Therefore, a younger beneficiary will be able to stretch out distributions over a longer period of time. When there are multiple beneficiaries, the contract will generally permit each beneficiary to select a different payout option, in which case each beneficiary will be able to use his or her own life expectancy.
If a trust is named as beneficiary, apparently only the five-year option (see above) is available, since there are no regulations providing for “see-through” trusts as in the case of a qualified retirement plan. Therefore, naming a trust as beneficiary, while often the only viable alternative (e.g., with minor children), should be avoided whenever possible. If a trust must be named as a beneficiary, the trust’s beneficiaries should be named as contingent or tertiary beneficiaries after the trust so that, if they have attained the trust’s final age of distribution at the death of the annuity owner, the trust can disclaim the annuity and permit the trust’s beneficiaries to become the direct beneficiaries of the annuity.
