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Trusts and Annuity Investments

Considerations when trusts own or are beneficiaries of annuities

Trusts are legal entities used in a variety of circumstances, such as passing assets to beneficiaries, facilitating charitable giving or ensuring the continuation of a business after an owner’s death.

Trusts usually contain assets that are managed by their trustees. Annuities can be owned by trusts in many situations and can be transferred in and out of many types of trusts. An existing annuity can be assigned to a trust as owner, and a new contract can list an existing trust as owner. Trusts can also serve as beneficiaries of annuity contracts. However, you should know how a particular type of trust will affect your annuity contract, especially the tax treatment. These types of questions should be answered by an attorney and/or tax professional.

Below are some of the situations that arise when an annuity is still in the deferral stage and is either owned by a trust or a trust is listed as a beneficiary of the contract’s death benefit:

Tax treatment of trust-owned annuities

There is some discrepancy regarding whether trust-owned annuities enjoy the same tax-deferral growth as annuities owned by people. The Internal Revenue Code states that annuities owned by entities such as corporations and trusts must pay tax on annual gains within the annuity. However, a trust-owned annuity can maintain its tax-deferral status as long as the “beneficial owner” is a person. So if a trust owns an annuity that benefits, for example, a surviving child, then it should grow tax deferred. If the trust funds are held by a business partnership, the annuity owned by the trust loses its tax deferral.

Annuity payouts to a trust upon the owners death

When an annuity’s owner dies, tax law states that the contract’s income can no longer be deferred and must pay out. If the contract’s owner was a person, there are four options for beneficiaries to receive payouts:

  • Receive the annuity’s value as a lump sum
  • Receive payments over a five-year period
  • Receive regular payments for life or other designated period
  • If the the beneficiary is a surviving spouse, he or she can assume ownership and keep the contract in force

But if the annuity’s beneficiary is a trust, the last two options are not available. That means the annuity will either have to be distributed as a lump sum or a series of payments over five years.

In some cases, this is not a problem. Where it does become a potential issue is when the annuity has a large value and the taxes must be paid on the lump sum or over five years. If the beneficiary were a spouse or another person, then the tax bill could be stretched out over his or her lifetime.

Whose death triggers a death benefit?

As stated, tax law stipulates that an annuity owner’s death triggers a payout of the contract’s funds. But what if the annuity is owned by a trust? Since a trust can’t “die,” whose death would trigger the annuity’s payout?

The tax code has deemed in these cases that the primary annuitant is the owner. Therefore, when a trust owns an annuity, the contract must be paid out upon the death of the primary annuitant, who is the person stated in the contract to receive the income generated by the contract.

This is simple enough in most cases but can get complicated when certain types of trusts are involved.

For example, a grantor trust is one in which the grantor, a term describing the person who creates the trust, maintains control over the trust assets. This is often done by a parent who establishes a trust for the benefit of a child.

A situation sometimes arises where the trust owns an annuity and the annuitant is the person for whom the trust was created, say the child of the trust’s grantor. While some insurance companies will stipulate that only the annuitant’s death — in this case the death of the child — can trigger annuity payouts, others will stipulate that the grantor’s death can also trigger mandatory payouts. Therefore, it is advised that in these situations the trust grantor understands how the insurance company will handle this situation before entering into a contract.

Transactions involving trusts can be complicated from a legal and tax perspective, and annuities are no different. If a trust is in anyway going to be involved in your annuity contract, it’s best to consult with legal and tax advisors to understand the different implications.