Retirement accounts and annuities used as accumulation vehicles can create significant tax-deferred account balances over time, with the caveat that eventually the tax bill must still come due.If the accounts are liquidated during life, the account owner faces the tax consequences; if the accounts are held until death, the tax liability falls to the beneficiaries instead.
However, in situations where it is most important to limit a beneficiary’s access to a trust – such as irresponsible spendthrifts, asset protection, and estate planning scenarios – there may be little choice but to accept the less favorable tax treatment, at least until/unless the rules change!
While non-qualified annuities (i.e., those NOT owned in a retirement account) do not subject their owners to required minimum distributions (RMDs) while alive, the beneficiary of an inherited annuity subject to post-death RMD rules that are very similar to those applicable to retirement accounts.
In fact, the rules for post-death RMDs from annuities under IRC Section 72(s) are virtually identical to those for retirement accounts under IRC Section 401(a)(9), where the word “annuity” is simply substituted for the word “retirement account” instead!
Accordingly, beneficiaries of inherited annuities generally have three options for how to take distributions after the death of the original annuity owner (note: because these rules apply after the death of owner under IRC Section 72(s)(1)(A), they are triggered even if a joint annuity owner is still alive! Similar to retirement accounts, one set of rules applies if the beneficiary is a “designated” beneficiary (i.e., a living, breathing human being), and another applies if the beneficiary is not an individual (i.e., a “non-designated” beneficiary).
Under IRC Section 72(s): – If the designated beneficiary is a surviving spouse, the beneficiary can continue the contract in his/her own name (known as the “spousal continuation” rule, similar to the spousal rollover of an IRA); – If the designated beneficiary is a non-spouse (i.e., any other living breathing human being the annuity owner’s surviving spouse), the beneficiary can stretch distributions over his/her life expectancy beginning in the year after death; and, – If the beneficiary is a non-designated beneficiary, the annuity must be liquidated within 5 years of the annuity owner’s death.
Notably, while these rules are substantively similar to retirement accounts, they are not precisely the same, due primarily to the fact that the rules for retirement accounts have been slightly “relaxed” under subsequent Treasury Regulations to make them easier to follow.Thus, for instance, stretching over the life expectancy of a non-spouse designated beneficiary of an IRA requires the first distribution to occur by December 31 of the year after death, while with an annuity it must actually occur within precisely 1 year (i.e., 365 days) of the annuity owner’s death.In the case of retirement accounts, the IRS and Treasury have created the “see-through” trust rules that allow post-death required minimum distributions to occur based on the life expectancy of the underlying trust beneficiaries.However, in the case of annuities, no see-through trust rules exist, compelling trusts to instead liquidate inherited annuities over the far-less-favorable 5-year rule!As a result, consideration of whether to use a trust as the beneficiary of an annuity must weigh the adverse tax consequences against the favorable/desired non-tax provisions of the trust.In some situations, using an annuity’s own beneficiary designation with “restricted payout” may be a viable alternative, saving on both the cost of the trust itself and preserving the stretch.