On an AgingOptions Radio Show, Vi from Olympia asked what the tax implications were for the beneficiaries if the trustee of a family trust that contains an annuity dies. Here’s a basic summary of tax considerations, however, you should consult your tax professional, lawyer or a financial professional.
An annuity is a long-term, interest-paying contract offered through an insurance company that acts as a “death benefit” and becomes payable to designated beneficiaries upon the death of the annuity’s owner. Annuities come in several different “flavors”.
Single or multiple premium-Payments are made either in a lump sum or a series of payments over a period of time.
Immediate or deferred-Immediate annuities begin paying out within a year of your last payment. Immediate annuities are generally single premiums. A deferred annuity makes income payments after an accumulation period, usually many years later.
Fixed deferred annuities-This annuity has a fixed interest rate set by the insurance company. The income payment you receive once the payout period begins is generally set.
Variable annuities-Your premiums are put into a separate account and invested at whatever risk level you choose. The payouts may be fixed or variable.
If the annuity is a qualified annuity it is taxed the same as IRAs, 401(k), or other qualified accounts. A tax deferred annuity allows you to compound yearly interest earnings without paying taxes making it safe for accumulating money but at some future date you must then pay taxes on the gains. A systematic annuity income payment spreads out the taxable gain over a number of years. The annuity will be subject to minimum distribution rules, making the distributions to the heir’s taxable income.
However, nonqualified annuities are taxed differently. They don’t provide a step-up in cost basis at death and the deferred earnings are taxed as ordinary income to non-spousal beneficiaries in accordance with the exclusion ratio. The exclusion ratio treats each annuity payment as part principal (the part paid into the account) and part interest. As a result, part of the payment will be taxable and part of it will not. The exclusion ratio is the total premium paid divided by the expected return. If the expected return is not based on life expectancy such as is the case for fixed term of years, the exclusion ratio is calculated by adding the total amount to be received. If the expected return is based on life expectancy (or joint life expectancy), IRS tables and multipliers are used to determine the total expected return.
When the beneficiary is the annuity owner’s spouse the IRS allows the account to be continued in the spouse’s name without tax implications. IRC 72(s)(3).
If the person who buys the annuity (the annuitant) dies after receiving some payments but not all payments, the balance is paid to any beneficiaries and those payments whether single payments or multiple installments are paid out tax free until the sum of all payments that were excluded from tax exceed total premiums invested, at which point any additional payments are fully taxable. Annuities purchased before Aug. 14, 1982, cash withdrawals, loans or received as surrenders are tax free until they equal the owner’s investment. After that they are taxed using FIFO (first in, first out) treatment. Distributions from annuities purchased after that date are fully taxable interest payments and only second as a recovery of non-taxable basis and using LIFO (last in, first out) treatment.
The beneficiary can elect to use the five-year stretch rule to have the distributions taxed over a five year period and not all at the same time. The proceeds can be received in one year or over a five year period, so long as all the proceeds are taken out during that time-frame. The IRS also allows another exception to this five year rule under which the beneficiary can elect to have the distribution taxed over his/her lifetime instead of the five year period. Such payments must start within one year of the owner’s death and payments must be made within the life expectancy of the beneficiary. IRC 72(s)(2).
Federal law requires that any gain in the contract be taxed whenever the owner dies whether the owner is an individual or multiple owners, meaning that the beneficiary will be responsible for income tax on the gains.
If the annuitant is different from the owner and the annuitant dies first, federal law does not require that taxes be paid unless the contract terminates except if the owner is a trust or other “non-natural” person. If a trust is a beneficiary, distribution options are limited to lump sum or five-year payout. If an IRA was used, the funds are subject to income taxes so any earnings will be taxed to the annuity owner as ordinary income. If the trust is acting as agent for a natural person, certain revocable trusts can be the annuity owner without eliminating the tax-deferred status.
A more comprehensive answer may be found here.