Executive Summary
Annuities have long enjoyed preferential treatment under the tax code - so extensive, that they merit an entire portion of the tax code, IRC Section 72, all to themselves. The favorable rules are generally intended to support the use of annuities as a vehicle for retirement savings and/or retirement income... and as such, the rules generally only apply in situations where annuities are owned directly by individual, living, breathing human beings who may in fact someday retire (known in the tax code as "natural persons").
Accordingly, whether annuities owned by trusts still enjoy tax-deferred growth depends upon the exact details of the trust. The rules do allow that when a trust owns an annuity "as an agent for a natural person" the contract can still keep its tax-deferral treatment, such as when it's owned by a revocable living trust; even if merely all the beneficiaries of the trust are natural persons, such as with a bypass trust for the benefit of a surviving spouse and children, favorable treatment is still available. However, if other beneficiaries are involved - even and including charities - a trust-owned annuity may lose its preferential treatment.
An even more complex point of intersection between annuities and trusts is when annuity contracts are transferred to/from a trust. The problem is a key section of the tax code designed to prevent the unrealized gains of annuities from being shifted to another individual through gifting; as a result, if an individual transfers an annuity "without full and adequate consideration" its gains are immediately recognized. By this rule will not apply to transfers to a revocable living trust, or most types of transfers out of a trust, in the case of some common estate planning techniques - like gifting an annuity to an Intentionally Defective Grantor Trust (IDGT) - the situation remains unclear, and clients and their advisors must be cautious not to accidentally create an unfavorable taxable event!
Trusts And Tax Deferral Of Annuities
The "standard" tax treatment for deferred annuity is that they are tax-deferred (note: the reason they're called "deferred" annuities is not because they're tax-deferred, but because they date of annuitization is deferred to the future; i.e., they have not yet been "annuitized"). However, IRC Section 72(u) actually limits this treatment in the event that an annuity is not held by a "natural person" (i.e., a living, breathing human being). Instead, the tax code prescribes that when an annuity is not held by a natural person - e.g., a corporation or other business entity - any gains in the contract will be taxable annually as ordinary income. The exception to the 72(u) "natural person rule" is that if an annuity is held "by a trust... as an agent for a natural person" it will still be eligible for tax-deferral treatment. (Michael's Note: It's important to remember that in the case of annuities owned inside of IRAs or other retirement accounts, the tax rules of retirement rules are controlling, including the tax-deferral treatment for retirement accounts; IRC Section 72 and its associated rules and regulations apply only to so-called "non-qualified" annuities held outside of retirement accounts.)
Unfortunately, the tax code itself does not describe what constitutes "an agent for a natural person" and the rules are not entirely clear from the supporting Treasury Regulations, either. In the original guidance from the Senate Report from the Tax Reform Act of 1986 (which created this code section, see page 567), Congress indicated that the point of the rule was that if the nominal owner was not a natural person but the beneficial owner was a natural person, the annuity would still qualify, such as where a corporation technically holds title to a group annuity for the pure benefit of the (natural person) employee participants.
In the context of trusts, the IRS has generally interpreted the rules in a similar manner, as evidenced by a series of Private Letter Rulings over the years. For instance, PLRs 9120024, 9204014, 9322011, 9639057, 9752035, 199905015, 199933033, and 200449017 all reviewed situations where various types of trusts would own an annuity and all the beneficiaries of the trust were natural persons; as a result, the IRS interpreted the annuities as being held by an agent for a natural person, retaining favorable tax-deferral treatment. In the case of PLR 9316018, the situation was even more straightforward - when a grantor trust owns an annuity, the contract retains tax-deferral status under IRC Section 72(u) by virtue of the grantor trust treatment alone. By contrast, in PLR 9009047, the trust's remainder beneficiary was a charitable organization and not a natural person, so the tax-deferral treatment was lost; similarly, in PLR 199944020 found that a partnership holding an annuity would not be eligible for tax-deferral treatment, as a partnership is a business entity unto itself and not merely the nominal owner for a natural person beneficiary.
The basic conclusion from the rules - while a formal legal agency status is not required (at least based on the most recent rulings), for a trust to qualify as an "agent for a natural person" all the beneficiaries, both income and remainder, current and future, must be natural persons.
Trust As Owner Of A Deferred Annuity
Given these rules for tax-deferral treatment of a deferred annuity, some situations of trust ownership are fairly straightforward.
For instance, if a grantor trust owns the annuity, it is clearly eligible for tax-deferred growth. This would appear to be true both given the general treatment of grantor trusts, and with the supporting guidance of PLR 9316018. Accordingly, if a revocable living trust owns an annuity, it would remain tax deferred, and there is no problem with having such a trust purchase and own an annuity. On the other hand, since annuities already pass directly to beneficiaries by operation of contract, they avoid probate without any need for ownership by a revocable living trust, raising the question of why individuals would choose to transfer an annuity into such a trust in the first place, unless for management in the event of disability. Nonetheless, to the extent that a revocable living trust does own an annuity, it can do so on a tax-deferred basis.
Another common situation of trust ownership is where an annuity is owned inside of a bypass trust, which is typically a non-grantor trust and thus a situation where proper determination of whether IRC Section 72(u) will apply is crucial. The aforementioned guidance indicates that the general rule is where all the beneficiaries of the trust - income and remainder - are natural persons, the trust should qualify as an agent for a natural person. However, this may create complications in situations where a bypass trust includes a charity amongst the remainder beneficiaries; given the presence of PLR 9009047, caution is merited, as it appears such a trust would not actually qualify for tax deferral treatment.
In the case of a situation like a special needs trust, though, the outcome is less clear. If the sole beneficiary/ies of the trust are natural persons (e.g., the disabled beneficiary, with other family members as remainder beneficiaries) the trust should be eligible for tax deferral. However, in situations where there is a Medicaid payback provision - such that technically, "the State" may be a beneficiary of the trust, ownership of an annuity may no longer be tax-deferred. However, this particular scenario has not yet been directly evaluated in any Tax Court case or Private Letter Ruling, and as such remains a "gray" area.
Transferring Annuities To/From Trust Owners
The scenarios discussed above where a trust may own an annuity and receive tax-deferral treatment are all situations where a trust purchases and initially funds the annuity itself. A related situation - with potentially differing outcomes - is where an existing annuity is transferred to (or from) a trust, rather than being purchased by it in the first place.
The reason annuity transfers are more complicated is not IRC Section 72(u) - pertaining to the ongoing tax-deferral treatment of an annuity - but instead IRC Section 72(e)(4)(C), which controls whether a transfer itself can be done without triggering the recognition any embedded gain on an annuity, and was created to prevent individuals from shifting the unrealized gains of an annuity to another person through gifting. Under this section of the tax code, if "an individual who holds an annuity contract transfers it without full and adequate consideration" any gains are recognized when the transfer occurs; in other words, the tax code treats it as though the contract was liquidated in a taxable event, and the proceeds were then transferred to purchase a brand new annuity.
In the case of a transfer to a revocable living trust, this is not an issue, as the annuity is not treated as transferred for income or estate or gift tax purposes, and accordingly there has been no "transfer" to which a full-and-adequate-consideration exchange can be considered. For tax purposes, the ownership is the same before and after the transfer.
Ironically, in situations where an annuity is transferred out of a trust, the transaction also does not trigger IRC Section 72(e)(4)(C), as the IRS reads the provision literally, and since it states that it must be "an individual who holds an annuity..." a trust that owns the annuity in the first place isn't an individual and therefore cannot trigger tax treatment by transferring the contract. Thus, in PLR 201124008, where an annuity was distributed in-kind by a bypass trust to its trust natural person trust beneficiary, the transfer was not taxable at the time.
However, in situations where the annuity is being transferred as a (taxable) gift to a trust, the situation is less clear. If the trust is not a grantor trust and the transfer is a gift, IRC Section 72(e)(4)(C) will clearly be triggered, even if all the beneficiaries are natural persons such that subsequent gains may again be tax-deferred once the trust owns the annuity. Perhaps the most confusing situation is when an annuity is transferred to an Intentionally Defective Grantor Trust (IDGT), which is a grantor trust for income tax purposes but outside of the individual's estate for gift and estate tax purposes. While some have contended that the transfer of the annuity to the IDGT should not trigger taxation upon transfer - it certainly wouldn't face ongoing under 72(u) since it's a grantor trust - it's difficult to claim that the annuity was not "a transfer without full and adequate consideration" when the grantor has to file a gift tax return to report the transfer in the first place! Notably, while popular Revenue Ruling 85-13 has indicated that a sale of property to a grantor trust should not trigger gain, as one cannot have a sale between a grantor and the grantor's trust, in this case the problem is actually that the annuity was not sold but gifted as a gratuitous transfer (without full and adequate consideration). Ironically, this suggests that while a sale of an annuity to an IDGT might avoid gains treatment, the gratuitous gift transfer of an annuity to an IDGT may trigger gain. Unfortunately, though, neither situation has been directed address on point in a Tax Court case or even via a Private Letter Ruling.
The bottom line, though, is simply this: while annuities can be owned by trusts in many situations, and transferred into or out of many (but not all) types of trusts, it's important to understand the particular details of the trust and its beneficiaries to determine the tax treatment of the transaction. When it comes to annuity and trust taxation, all trusts are not created equal!
For those looking for additional objective information regarding the technical rules and taxation of annuities in general, check out my book "The Advisor's Guide To Annuities" as well!
Thanks for sharing Michael. I’ve always been interested in the concepts put forward at http://www.ricetrust.com, but if possible without a high cost annuity.
You could use the Jefferson National VA. Only fees are $20/month plus expense ratio for funds you choose.
OR a fee based annuity with a low or no M&E platform. If you haven’t researched this in the last year there are lots of new low cost variable
annuities.
Wow. Great information. Thanks for the write up!
Michael,
What happens when there are multiple discretionary trust beneficiaries in multiple generations? Can an existing such trust purchase annuities? Who would be the beneficiary(s) of the annuities?
This is the best analysis of the annuity trust intersection I have found, thank you Michael. Joint-annuitants husband and wife draw a fixed annuity with wife as beneficiary, maturity in 30 years. They subsequently fund a Grantor Trust 5 years later with the annuity, the trust becomes the annuity beneficiary. The grantor dies, the spouse chooses to continue the policy till maturity. The insurance company sends statements till maturity. At maturity the insurance company maintains the trust is beneficiary not the spouse, so they pay a death benefit not the maturity value. Question to blog community: How common is this surrender pay-out scenario with annuities held in a common family trust?
Les,
Oy, I would strongly urge clients NOT to adopt the structure you describe here in the first place, as it begs for problems.
The fundamental issue here is that with a jointly owned contract (or joint annuitants in a trust-owned contract), the annuity should have been required to pay out at the FIRST death. If the wife was beneficiary, the wife could do a spousal continuation, but that should have been done by retitling the annuity INTO her name as the beneficiary. If the annuity remained in trust name but operated with spousal continuation, it didn’t really follow the rules as written in the first place, so you’re largely at the mercy of the annuity company for how the situation gets handled at this point. Arguably if the policy wasn’t retitled into the wife’s name after the first death, it should have failed as an annuity at that point already? :/
– Michael
-Vey! How common is this scenario? There must be millions of these trusts out there, the annuitants are no wiser until the annuity maturity date – maybe 25 years after the trust inception. What do Private Letter Rulings show? To complicate matters more the annuitants forget details, insurance companies acquire annuity companies and after 25 years the paper-trail is lost.
Exchange the Annuity before the Taxpayer dies! PLR 200622020: “Taxpayer is an individual. On Date 2, a non-qualified Annuity (Annuity) was purchased and held by Trust, a revocable trust with Taxpayer and Spouse as Grantors and Trustees. Spouse died on Date 3. Upon the death of Spouse, Taxpayer asked the insurance company that issued the Annuity to exchange the Annuity in the Trust’s name for an annuity in Taxpayer’s name. The insurance company refused to do so.”
Just to show how arbitrary this logic is, here are the statutes from US Title 27 Par. 72(u)(s) describing who benefits from tax deferral:
For purposes of this paragraph, holding by a trust or other entity as an
agent for a natural person shall not be taken into account, ie a trust qualifies as a vehicle for tax deferral.
For purposes of this subsection, the term “designated beneficiary”
means any individual designated a beneficiary by the holder of the
contract.
If the designated beneficiary referred to in paragraph (2)(A) is the
surviving spouse of the holder of the contract, paragraphs (1) and
(2) shall be applied by treating such spouse as the holder of such
contract.
If any holder of such contract dies before the annuity starting date,
the entire interest in such contract will be distributed within 5
years after the death of such holder.
translation:
the spouse
the spouse
the spouse
not the spouse
Absurd.
Somewhat confused about the affects of 72(u) on a Grantor Charitable Lead Trust (the qualified reversionary type). You seem to quote one PLR that grantor trust status is enough to allow the tax deferral, while later you note that income beneficiaries can also disqualify the trust from tax deferral. Please clarify this point.
Thanks,
Yosef,
If it’s a grantor trust, it’s a grantor trust, period.
If it’s NOT a grantor trust, it’s a non-natural person entity, and now evaluating income beneficiaries is relevant to determine if the trust is acting as an agent for a natural person.
– Michael
HI Michael, fantastic info – thanks. In the case of an annuity within a trust, if the taxes are deferred, when the taxes are ultimately paid, are they calculated at the trust rate or the “natural” person rate? Does having the income flow out to the beneficiary via a K-1 make a difference? Thanks, Sharon
Sharon,
Oversimplifying trust tax accounting slightly, basically the tax consequences of the withdrawal follow where the dollars go.
When the annuity withdrawal goes to the trust, the tax consequences initially go to the trust.
If the trust passes those dollars through to the beneficiaries (in the same tax year), the tax consequences flow through as well (the trust deducts the income from its return, reports the income on the K-1s to the beneficiaries).
If the trust gets the dollars and keeps the dollars (that tax year), it keeps the tax consequences and reports on the trust’s Form 1041.
– Michael
Is there an option if the annuitant is still alive and is the grantor on the trust for them to pay the taxes on the annuity themselves even if the annuity payment was sent directly to the trust and the grantor never actually controlled the money?
Excellent article. I own a variable annuity that I would eventually like to transfer to my heirs in the most tax efficient manner. If I change ownership to a revocable living trust that would become irrevocable at my death, would that be considered a taxable event? I would also change the beneficiary of the annuity to be the trust so that tax deferral could continue after my death. So at my death no income tax would be due and tax deferral remains intact until the beneficiary takes a distribution from the trust. Am I interpreting the regulations you cited correctly?
FBN,
Presuming you are the annuitant of your variable annuity as well as the owner, no this strategy will not work.
When the owner of an annuity dies (or the annuitant in cases where the annuity is owned by a trust), the annuity MUST begin its payouts. The ownership of the annuity is irrelevant – when a death occurs, payouts must begin to beneficiaries.
And the trust-as-beneficiary rules for annuities are even less favorable, as there’s generally no way to stretch distributions out over life expectancy. See https://qa.kitces.com/blog/the-problem-with-naming-a-trust-as-the-beneficiary-of-an-annuity-and-using-a-beneficiary-designation-with-restricted-payout-form-as-an-alternative/
The bottom line is that for a variable annuity that you own and where you’re the annuitant, there is no way to extend its full tax deferral beyond your death. At best, you can obtain partial tax deferral beyond death by stretching distributions out over the life expectancy of the beneficiary, and if that’s your goal, having the trust be the beneficiary of the annuity would lead to the WORST possible outcome (regardless of whether the trust is the owner or not).
– Michael
The beneficiaries (after both my wife and I die) would be my adult children. My goal is to protect this asset from being considered a marital asset of my children in the event they were to get divorced. I do not want an ex spouse to be able to get 1/2 of the account value. This is easy to do for other assets in trust but now I see no way to protect the VA if placing it in a trust is unwise.
If we buy VA in a revocable trust, is it tax deferred? The beneficiaries are all natural people.
I meant to say Irrevocable trust (below)
Seems like you are offering legal opinions. Are you a lawyer?
Michael,
I am the trustee of my mother’s trust. She is still living but incapacitated with Alzheimer’s. Upon recommendation of ML where her portfolio is held in Trust, I transferred one of her annuities into her revocable trust. This annuity was one of ML’s investment products sold to her through ML but it is held by another company. It shows up on ML statements as part of her portfolio. She has never been declared incompetent by a court, rather took care of signing over Trusteeship and POA prior to her incapacity. The beneficiaries of the annuity are natural persons not the trust. There have been no distributions made from the annuity and most likely there will not be before her death. What concerns me from your article is that after reading all the way through her trust, I am not sure it qualifies for “an agent for a natural person”. At the very end of instructions for distributions in the trust, which goes through all the generations of descendants, it states that if there are no beneficiaries living it is distributed to a university.
Have I made a mistake transferring this annuity to her trust and if so can I transfer it out?
Mari,
Not an issue here. When it’s a revocable trust, the core beneficiary is simply the owner/grantor. Everyone else is a mere successor beneficiary that isn’t considered.
Looking to subsequent beneficiaries is only a concern in irrevocable trusts where all those more distant beneficiaries may actually have a currently vested interest, not just a successor interest after the current owner dies.
Having a revocable living trust as BENEFICIARY can be more problematic – see https://qa.kitces.com/blog/the-problem-with-naming-a-trust-as-the-beneficiary-of-an-annuity-and-using-a-beneficiary-designation-with-restricted-payout-form-as-an-alternative/ – but mere revocable living trust ownership is not an issue for the agent-of-a-natural-person exception. At least with all the PLRs we’ve seen from the IRS thus far on this.
– Michael
Michael,
Thank you so much for replying with this information. I was worried that I may have made a mistake on the advise of ML. Is there any advantage of transferring an annuity into trust since I also have POA?
Hi Michael,
Do you know if there have been any changes with respect to triggering unrealized gains when transferring/gifting to an irrevocable trust?
My client owns a deferred fixed index annuity that has over $100k in gains. She and her family want to transfer the annuity to an irrevocable trust (in which all beneficiaries are natural persons) in order to remove any remaining funds in that FIA from her estate upon her death, for MA estate tax purposes. However, we do not want to trigger recognition of those gains by transferring the trust to the annuity.
I have talked to a couple of different people and have been given conflicting answers.
Thank you for your help,
Susan
Hi, I’ve just come upon this article in the past few days. What about making a Special Needs Trust the beneficiary of a variable deferred annuity, where the death benefit (including any deferred income/appreciation) is payable to the SNT? This is being considered instead of purchasing a whole life policy, since I’m 67 and premiums for a $500,000 policy are off the charts.