Estate Planning With Deferred Annuities in Retirement: Reducing Your Beneficiary’s Tax Burden

estate planning

“Are there any ways I can use annuities to prevent the government from taxing me to death when I die?” While the client was only half joking, he did have a point. Many of the retirees I meet with have worked their entire lives to build up their assets but now are wondering what will happen to those assets when they’re not around. Annuities, which are designed to supplement retirement income, also offer the reassurance of a death benefit to your beneficiaries. The death benefit will typically be subject to normal income tax unless it is non-qualified annuity that was purchased with after-tax dollars.

Who Has to Pay Estate Taxes?

As of 2016, if your estate is worth less than $5.45 million, your estate may not have to file an estate tax return.1 While that amount sounds like plenty, when you consider the assets you’ve accumulated over a lifetime, it’s possible that your heirs might run into some issues. This is especially true if you have business or property holdings.

The government uses fair market value to assess the value of real property in your estate. The value of these properties and business holdings could push you into a taxable territory. Your heirs could run the risk of having to liquidate your assets to cover your tax bill. To avoid that, some choose to use deferred annuities and trusts to reduce their total taxable estate.  

How Deferred Annuities Can Help You Manage Your Estate

One major benefit to using deferred annuities in your estate planning is the level of control they allow you. This is often accomplished by using deferred annuities to fund a trust. A trust is simply a financial arrangement in which the trustor entrusts a certain asset (in this case, the annuity contract) to benefit a third party (the beneficiary). The beneficiary will receive the proceeds from the trust upon the owner’s death, but won’t have direct control of those benefits.

Trusts are a means of transferring ownership. Annuities must have a natural person as the annuitant because they’re based on a life expectancy. Those annuities can then be gifted to the trust — up to $14,000 per recipient per year can be gifted and excluded from federal gift tax.

Making an annual gift to the trust allows the benefits to accumulate for your beneficiary, while removing those amounts from your eventual taxable estate. This is because the trust is considered the annuity owner, and not you.

On top of that, the annuity contracts can still enjoy their tax-deferred status on any interest credited to the annuity value. The trust must be set up to benefit a natural person and not an entity (like a charity or business). If so, the annuity will enjoy tax-deferred status until withdrawals are made.2 In addition, to the other annuity benefits, such as the potential for accumulation and a guaranteed lifetime income stream, the deferred annuity within the trust offers another benefit above and beyond the tax benefits.

Controlling How Your Heirs Spend The Funds

We all have a relation or two who isn’t particularly good at managing money. Making an individual who has trouble managing money the beneficiary of a large lump sum can end in disaster. This could be especially true in the case of younger beneficiaries. A trust allows the giftor of the annuity to give someone the benefit of the annuity without allowing them direct control of it.   

A death benefit in an annuity usually gives the beneficiary control in that he or she can choose to cash out the contract in a lump sum. Putting the deferred annuity into a trust keeps the beneficiary from being able to take that lump sum payout because the contract is owned by the trust. It’s the trustee who manages the contract and decides how the benefits are going to be paid out. The trustee can choose to continue making regular payments or allow the individual to control the annuity based on his or her own judgment.

Of course, this requires choosing a trustee who is responsible enough and knows your beneficiaries well enough to know when it’s right to give access to the funds. Often, what people choose to do is to have a financial planner or accountant manage their trust as an unbiased third party.  

You generally shouldn’t make yourself a trustee if the goal of the trust is to ensure the funds aren’t in your name. And while each individual’s situation is unique, it’s usually not a good idea to assign the trustee position to a spouse for the same reason. Finally, remember that the trust has to only benefit natural people. Even if it’s just one entity that’s listed as a beneficiary, like a charity, this can end the deferred tax status of the underlying annuity.

Using annuities in estate planning can be very beneficial, but it’s also a complex process. It’s not as simple as buying a life insurance policy or assigning death benefits to heirs, but if done right, can help reduce current and future taxes on your own earnings and estate. If you’re interested in purchasing an annuity for this purpose, then you might want to talk to a financial professional in Retirement HQ’s network to explore your options.

By contacting RetirementHQ, you may be offered information regarding the purchase of insurance products. All of our financial professionals are licensed insurance agents. Additionally, some individuals may also be registered with a broker/dealer or as an investment adviser. Our financial professionals do not offer estate planning, tax or legal advice. Always consult with a qualified advisor concerning your own situation.

Show 2 footnotes

  1. “Estate Tax,”, Internal Revenue Service, May 20, 2016.
  2. “26 U.S. Code § 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts,” LII / Legal Information Institute, Cornell University Law School,  May 20, 2016.