Often, annuities and trusts are the best way to save for retirement and leave a legacy for your loved ones. However, when combined into what’s known as an annuity trust, they can provide powerful benefits, such as predictable income, tax advantages, and greater control over how you pass down your assets.
If you’re considering using an annuity trust for your financial or estate planning, let’s review what it is and how it works.
What Is an Annuity Trust?
An annuity trust is a financial arrangement in which you deposit assets, such as cash or investments. These assets are then managed by a trustee (either an individual or a financial institution), which uses them to fund an annuity for a named beneficiary.
Often, this type of arrangement is used for;
- Retirement income
- Assisting a family member with ongoing needs
- Structured charitable giving
- Long-term care planning
Simply put, it ensures your money is protected, managed wisely, and distributed according to your wishes.
Understanding Annuities and Trusts
The first step is to understand how annuities and trusts can work together.
Annuities: A guaranteed income stream.
In an annuity, money is saved for the future, usually for retirement, through a contract with an insurance company. In return, the insurance company pays you back in predictable installments once you have built up the funds.
With annuities, you avoid the risk of running out of money in retirement since you are guaranteed income for life. In the world of annuities, there are different types:
- Fixed annuities. You’ll get a set rate and regular payments.
- Variable annuities. Depending on investment performance, payments may vary.
- Immediate annuities (SPIAs). After purchasing a lump sum, you should begin receiving payments almost immediately.
- Deferred annuities. Funds are accumulated over time, and payouts are made later.
Trusts: Managing and distributing your assets.
Trusts are legal agreements in which you (the grantor) transfer assets to a trustee, whose responsibility it is to manage and distribute those assets to the beneficiaries during or after your lifetime.
The purpose of a trust is to avoid the lengthy probate process and ensure that your assets are distributed according to your wishes. Generally, a trust involves three parties;
- Grantor (or Settlor). An individual who creates and funds a trust.
- Trustee. A person or entity responsible for administering the trust in accordance with the grantor’s instructions.
- Beneficiaries. Assets or income from a trust are distributed to individuals or organizations.
Trusts can be revocable or irrevocable:
- Revocable trusts. At any time, the grantor may modify or terminate the trust. In addition to being flexible, these trusts do not provide creditors with protection and are included in the grantor’s taxable estate.
- Irrevocable trusts. Once a trust has been established, it cannot be changed or canceled. As the assets are usually removed from the grantor’s taxable estate, these trusts can help reduce estate taxes.
Can You Put an Annuity in a Trust?
It’s possible to place an annuity into a trust. To do this, however, requires careful planning and consideration of the tax and legal implications. But a financial planner, tax advisor, and estate planning attorney are all always recommended before moving forward.
Here are some key points to consider when putting an annuity into a trust.
Trust agreement.
The trust and annuity rules are outlined in this section. It specifies when, how, and under what conditions the money is distributed.
Type of trust.
Whether you choose a revocable or irrevocable trust depends on your control, tax situation, and whether the assets are protected from creditors or subject to taxation.
Beneficiaries.
Specify how and when the annuity payments will be distributed to the people or groups who will benefit.
Annuity selection.
To achieve your financial goals, select the appropriate type of annuity. As an example;
- If you want your trust to start generating income immediately, an immediate annuity is a suitable option.
- If you want your funds to grow, a deferred annuity is a better option.
Tax impact.
This part can be somewhat challenging. While annuities grow tax-deferred, adding them to a trust can lead to unexpected tax consequences — such as triggering gain taxes. In this case, you should consult an experienced tax advisor.
State laws.
There are different rules for trusts and annuities in every state. To ensure everything is legal, ensure that your plan follows your state’s laws.
Who’s the trustee?
It is the trustee’s responsibility to manage the annuity and trust according to your instructions. As such, choose someone responsible, knowledgeable, and professional (like a trust company).
Ongoing review.
Be sure to review and update your trust and annuity regularly to ensure they meet your goals and keep up with the changing laws.
Transferring an Existing Annuity to a Trust
Already own an annuity? If so, you can transfer it into a trust. However, proceed with caution.
- Ownership matters. For payments to continue after your death, the trust should either be the owner from the beginning or correctly listed as the beneficiary.
- Watch out for taxes. If your annuity has grown in value, moving it into a trust may be taxable. You may end up with a substantial tax bill if you make this decision without consulting a professional.
Types of Annuity Trusts and Their Tax Implications
Choosing the correct type of trust affects the tax treatment of the annuity within it:
Revocable Trusts and Annuities
- Taxation. In the case of annuities, the income is taxed in the same manner as if the grantor owned the annuity.
- Estate inclusion. For tax purposes, annuities in revocable trusts are included in the grantor’s estate.
Irrevocable Trusts and Annuities
- Taxation. There is no tax treatment of the trust as a separate entity. If the annuity generates income, the trust must pay taxes on it.
- Distributions. Taxes are paid at the individual rates of beneficiaries when income is distributed to them from the trust.
- Estate exclusion. In general, irrevocable trust assets do not contribute to the grantor’s estate.
When Should You Use an Annuity Trust?
The following are some reasons why an annuity trust might be a good investment;
- Steady income. Beneficiaries of an annuity can receive a consistent income, which is particularly beneficial for individuals who require financial support for education or healthcare.
- Avoid probate. With irrevocable trusts, assets can bypass the probate process, allowing them to be distributed more quickly and privately.
- Tax benefits. With the right structure, annuities can help reduce estate taxes and enable tax-deferred growth.
- Predictability. Fixed annuities allow beneficiaries to plan for the future more accurately due to predictable payouts.
- Control over distribution. Even after your death, you can control how and when your assets are distributed through a trust.
Possible Drawbacks
In addition to their many advantages, annuity trusts also have a few disadvantages:
- Lack of liquidity. In the case of annuities, accessing the principal early can carry penalties.
- High fees. Variable annuities, particularly those that have high fees, can reduce your returns.
- Limited investment choices. If you choose to purchase an annuity, you may be limited to the investment options offered by the contract.
- Complexity. There are several complexities involved when combining annuities and trusts. To avoid mistakes, you need expert help.
- Inflation risk. Inflation may cause fixed annuities to lose value over time.
- Trust maintenance costs. When setting up and maintaining a trust, there are associated costs, including attorney fees and trustee fees.
Alternatives to Using an Annuity in a Trust
Consider these alternatives if you believe annuity trusts are too complicated:
- Direct Beneficiary Designation. By naming beneficiaries directly on your annuity, you bypass probate and go directly to them.
- Joint Annuity with Spouse. With a joint annuity, the surviving spouse continues to receive payments after the death of the original annuitant.
- Charitable Gift Annuity. After your death, the remaining funds will go to the charity you donated to in exchange for income payments.
- Charitable Remainder Trust (CRT). In this type of trust, you or your beneficiaries receive income, while a charitable portion is retained.
Final Thoughts: Build a Plan That Fits You
With annuity trusts, you’re able to manage your assets, provide support to your family, and create a lasting legacy for your loved ones. Despite their simplicity, they offer a combination of income security and estate planning flexibility. But there are legal details, tax rules, and long-term commitments involved.
It’s a good idea to consult with a financial advisor, an estate attorney, and a tax expert before establishing your estate plan. With the right team, you can develop a strategy that aligns with your life, goals, and family’s future.
FAQs
What’s the main benefit of putting an annuity in a trust instead of just naming a beneficiary directly on the annuity?
In addition to giving you control over the distribution process, you also have the potential to protect your assets and avoid the probate process. However, a trust allows you to specify how and when the income is distributed (e.g., monthly payments, for specific purposes, or staggered over time), rather than a lump sum distribution.
Additionally, an irrevocable trust can protect assets from creditors and judgments, unlike a direct beneficiary designation.
Are annuity trusts only for very wealthy people, or can average individuals use them?
Although high-net-worth individuals with complex estate plans often utilize annuity trusts, they can also benefit average individuals. As an example, an annuity trust might be a suitable solution whether you are wealthy or not, if you have special needs children, loved ones who are unable to manage their finances, or if you need a guaranteed income stream (such as education funding). They’re not for everyone, however, due to their costs and complexity.
What are the biggest tax traps I should be aware of when considering an annuity in a trust?
The biggest tax traps include:
- Taxation of gains upon transfer. When an existing annuity with accumulated gains is transferred into a trust, those gains are immediately taxable.
- High trust tax rates. A trust that retains annuity income (but does not distribute it) is subject to potentially high trust taxes.
- Loss of “stretch” provisions. The tax-deferred distributions from a non-spouse beneficiary annuity may be lost if the trust structure is too complex. Before making any transfers, consult a tax professional.
How do I choose between a revocable and an irrevocable trust for my annuity?
The choice hinges on your primary goals:
- Revocable. Consider whether you need asset protection from creditors, estate tax reduction, and flexibility to adjust the terms. Taxable assets remain in your estate.
- Irrevocable. Decide whether you are protecting your assets from creditors, reducing your estate tax, or planning for Medicare or Medicaid — this is important to you. Once the assets are transferred, you lose control over them. Depending on your particular circumstances, your financial advisor and estate planning attorney will help you balance these trade-offs.
What’s the role of the trustee in an annuity trust, and who should I choose?
A trustee plays an important role. They manage the trust assets (including the annuity), make investment decisions (if applicable), handle all paperwork, and ensure distributions are made according to your trust document. As fiduciaries, they must act in the best interests of the beneficiaries.
Depending on your preference;
- An individual. A trusted family member or friend. Just make sure they understand the complexity and the commitment.
- A professional trustee. Generally, banks, trust companies, or professional fiduciaries offer expertise, objectivity, and continuity, but they charge fees. Based on the amount of assets, the complexity of the trust, and the capabilities and availability of the individual or institution, you should make your selection.
Image Credit: Photo by Mikhail Nilov; Pexels
