Inherited Annuities

Inherited Non-Qualified Annuities for Spouses, Non-Spouses, and Trusts

Inherited Non-Qualified Annuities for Spouses, Non-Spouses, and Trusts

It is somewhat common to be dealing with clients who have accumulated significant non-qualified annuity account values.  As a result of tax deferred Section 1035 exchanges over many years, it is not uncommon for business owners, professionals, and wealthy individuals to have large six figure or even seven figure account balances.  The original cost basis continues to carry over through a series of Section 1035 exchanges over many years.

Non-qualified annuities have become valuable financial assets that can be managed and preserved over a long period of time.  The annuities may be fixed, indexed, or variable contracts.  This preservation and management can be accomplished for spouses and non-spouses even long after the owner of a non-qualified annuity has died if certain distribution rules are followed.

In most cases, non-qualified annuities can remain tax deferred all the way until the death of the owner.  Income taxes on the gain amount in excess of cost basis will eventually need to be paid by the beneficiary of the annuity after the annuity owner has died.  This is known as income in respect of decedent (IRD).  If planned well, this taxable IRD gain amount can be spread over many years after the death of the annuity owner in the form of an inherited non-qualified annuity.

Here is a detailed summary of the distribution options available to spouses, non-spouses, and trusts for inherited non-qualified annuities under IRC Section 72(s)

A) Spouse Designated Beneficiary … Inherited Distribution Options

    1. 5 year rule. Account value must be totally distributed within 5 years of death        (IRC Section 72(s)(1))
    2. Life expectancy rule. Annuitized life expectancy distributions must start no later than 1 year after the death of the holder-owner (IRC Section 72(s)(2))
    3. Spouse can continue the existing contract as his/her own and name a new beneficiary. The surviving spouse can continue tax deferral of gain in excess of cost basis all the way until death if desired (IRC Section 72(s)(3))

B) Non-Spouse Designated Beneficiary … Inherited Distribution Options

    1. 5 year rule. Account value must be totally distributed within 5 years of death       (IRC Section 72(s)(1))
    2. Life expectancy rule. Annuitized life expectancy distributions must start no later than 1 year after the death of the holder-owner (IRC Section 72(s)(2))
    3. PLR 200313016 also allows a life expectancy payout for inherited non-qualified annuities based on the Single Life Table of Treas. Reg. 1.401(a)(9)-9. This required annual inherited distribution must start no later than 1 year after the death of the holder-owner.  Presumably, this would allow a deferred annuity type of product with an irrevocable income rider withdrawal option to be utilized.  IRS ruled in PLR 200313016 that this method would satisfy the life expectancy requirement of IRC Section 72(s)(2).

C) Trust or Estate as Beneficiary … Inherited Distribution Options

    1. 5 year rule. Account value must be totally distributed within 5 years of death       (IRC Section 72(s)(1))
    2. Life expectancy rule. It is not clear if the Life Expectancy rule can be used where a trust or estate is the beneficiary of a non-qualified annuity.  No Treasury Regulations or IRS rulings exist for non-qualified annuities where a trust or estate is the beneficiary.  A trust or estate is not considered to be an individual “designated beneficiary” under IRC Section 72(s)(4)).  Legally, a trust or estate may be named as beneficiary, but it is not clear whether the life expectancy rule can be used.

Technical Tax Rules for Inherited Non-Qualified Annuities

There are certain technical rules that apply to the post-death distribution methods described above.  Here is a short list of the most important rules for inherited non-qualified annuities:

  • Generally, the death of the holder (owner) of a non-qualified annuity terminates the contract and required distributions from the contract must commence under the rules of IRC Section 72(s). One of the distribution options described above may be chosen with the existing annuity carrier.  An exception is the option for a spouse beneficiary to continue the contract as his/her own under IRC Section 72(s)(3).  The new spousal continuation contract is still eligible for a tax free Section 1035 exchange to a non-qualified annuity with another carrier.
  • For income tax purposes, the distribution option chosen will be governed by either the “LIFO” distribution rules of IRC Section 72(e) or the “exclusion ratio” rules of IRC Section 72(b).
  • Where an Irrevocable Trust is the owner of a non-qualified annuity, IRC Section 72(s)(6) states that the “holder” for purposes of post-death distributions of a non-qualified annuity shall be the primary annuitant. With an Irrevocable Trust as owner, it’s important to determine who will be the annuitant … either the older parent (grantor of the trust) or the younger adult child (beneficiary of the trust).
  • There is currently no authority in the Code, Treasury Regulations, or Revenue Rulings for post-death transfers of non-qualified annuity funds from one annuity carrier to another annuity carrier after the holder-owner has died. However, in PLR 201330016, IRS permitted a post-death exchange of non-qualified annuity funds as long as the transfer was made directly from the old annuity carrier to the new annuity carrier.  The IRS characterized this transaction as a permitted tax-free exchange of annuity contracts within the scope of IRC Section 1035(a)(3).  Each annuity carrier involved in the exchange transaction must be consulted to determine their own business practices for this post-death situation.

 

BSMG can provide access to multiple annuity carriers to fund non-qualified annuities both during lifetime and as an inherited non-qualified annuity post-death.  Contact your BSMG Annuity Advisor to design a post-death annuity distribution plan for your best annuity clients.

 

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net