Your client calls you, having just signed freshly drafted estate planning documents, including a new revocable trust. The purpose of the call: to accomplish the attorney’s directive of funding the revocable trust. Does that directive include the client’s nonqualified annuity (NQA)? Probably not.
Clients may be giving up more than they get when they name a revocable trust as owner of the NQA. At risk with such ownership are both “spousal continuation” and “nonqualified stretch."
Spousal continuation allows a surviving spouse (if named as beneficiary) to become the new owner and annuitant when the owner passes away. This allows for continued tax deferral beyond the original contract owner’s death, when payments, and therefore income taxes on any gains, may otherwise be due.
Nonqualified stretch allows an individual, but not an entity, to take death benefit proceeds as either lifetime (annuitization) or life expectancy (systematic) payments. In contrast, entities must take all death benefit proceeds (and therefore pay any income taxes owed) within five years of the original owner’s death. Payments beyond five years—either lifetime or life expectancy—allow a beneficiary to manage more effectively the income tax consequences of inheriting a NQA that has performed well and has a value well in excess of its original cost basis.
Naming the revocable trust as the contract’s owner forfeits the tax-favorable beneficiary bonuses of either spousal continuation or nonqualified stretch because the trust, if named as owner, should also be named as beneficiary. As agent, the trustee has a host of fiduciary duties regarding the trust and its beneficiaries. These duties include acting prudently and in the best interests of the trust’s beneficiaries. At a minimum, these duties prevent the trustee from inadvertently disinheriting a trust beneficiary by naming individuals, rather than the trust itself, as the annuity’s beneficiaries.
What could go wrong with such a workaround? The trust may be amended or provide that descendants take per stirpes, whereas the NQA’s beneficiary designation may provide for a per capita dispositive scheme. In short, the only way to ensure that the trust’s beneficiaries receive the NQA’s death benefit proceeds is to name the trust as the beneficiary of the NQA. Doing so dictates a five-year payout.
While it may be tempting to harness the benefits of a revocable trust when titling a NQA, trust ownership may not be necessary to achieve many, if not all, of these benefits. Such benefits include the ability to avoid probate on trust-owned assets and asset management in the event of incapacity. Since annuities transfer ownership at death by beneficiary designation, bypassing probate is readily accomplished by keeping beneficiary designations up to date. A durable power of attorney provides the ability to manage assets not owned by the revocable trust.
Bottom-line, think twice before naming a revocable trust as the owner of a NQA. Weigh the benefits of such ownership against what’s being lost. And consider transferring ownership of revocable trust owned annuities to the trust’s grantor (the individual who created the trust). Since the revocable trust and the grantor are treated as the same taxpayer, the transfer is accomplished without triggering the recognition of any contract earnings.
For additional information about NQA structuring, please contact the Retirement Strategies Group at (800) 722-2333, extension 3939, or email us at RSG@PacificLife.com.
For financial professional use only. Not for use with the public.
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