Military Finances 301: Should You Put an Annuity in a Trust?
Taxes Estate PlanningAnnuity Basics
In the case of a deferred annuity, you deposit funds into the annuity and any taxes on the income in the annuity is deferred until such time as when you take the funds out of the annuity (prorated between contributions and income). They operate much the same as a non-deductible Traditional IRA.
The owner and beneficiary of the annuity do not have to be the same person, so you could name a child, as an example, as the beneficiary of an annuity you own. This will be a gift (not of a present interest) that may trigger the need to file a gift tax return.
Since there is a beneficiary of the annuity, it transfers upon death without probate and is not controlled by a will.
Why Put an Annuity in a Trust?
Since an annuity passes outside of probate a compelling reason to transfer one to a trust is not evident. Except for one thing, trusts are really bad when it comes to taxes. The tax brackets for trusts (assuming they retain earnings) are extremely compressed. In 2024, the 37% tax bracket starts at $15,200 for ordinary income inside a trust. The 20% long-term capital gains tax starts at $14,650.
So, a trust may not be a great place to accumulate wealth for someone. Unless…the income is generated inside an annuity. As an example, you have a special needs child and want to set up and start funding a Special Needs Trust for your child. If you do that via taxable investment accounts, you’re likely to pay a lot of income tax inside that trust. Or perhaps you have a desire to leave assets for your children to use in retirement, but you want to shelter those funds from creditors (lawsuits) or divorce and you want to invest over time to build those assets. Again, an annuity would defer taxes on the income.
When money does start coming out of the annuity, it will be taxed at the beneficiary’s rate if it is paid out to the beneficiary. If the earnings paid out are retained by the trust, they are taxed at the rates listed above (remember a portion of the distribution will be after-tax).
Gotcha’s if You Try this Technique
The rules concerning tax deferral only apply if the annuity is held by a “natural person”. So, it would appear on first glance that the deferral would not occur if the annuity were held by a trust. But there is an exception (there always is an exception in the tax code). If the annuity is held by a trust as an agent for a natural person, it will be eligible for tax-deferral. If all the beneficiaries, both income and remainder, current and future are natural persons, income should be tax-deferred. Additionally, if the trust is a grantor trust, an annuity will retain tax deferral.
If you transfer an existing annuity to a trust, you are likely to trigger recognition (and taxation) of the earnings/gains received to date.
More likely than not, there may be penalties if withdrawals start before the grantor or beneficiary reach 59 ½. You’ll want to confirm the rules in your case before you go down this path.
Complicated Stuff
You’ll want to make sure you work with an attorney that isn’t doing OJT when putting together the trust and you’ll probably want an experienced insurance profession involved too (look for one with the CLU designation) when putting this plan together.
Military Finances are Different
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If you found this article useful, you might like the following blog posts:
Military Finances 101: What Is a Living Trust?
Military Finances 301: Avoid These Blunders When Setting up a Living Trust
Military Financial Planning 101: A Primer on Trusts for Estate Planning