High inflation, volatile markets and rising interest rates are just some of the challenges that many trustees may face when managing trusts. Trust-owned annuities may help facilitate generational wealth transfer plans by leveraging tax-deferral*, income control and diversified investment options.
Managing a trust today has its challenges. High inflation, volatile markets, and rising interest rates have made it more difficult for trustees to ensure that trust assets are properly invested to achieve the trust’s defined goals and objectives. Tasked with ensuring invested assets are positioned to drive growth, preserve capital, and manage the ever-present sting of taxes and expenses, trustees are increasingly looking to trust-owned annuities as a strategy for today's investment environment.
Trust-owned annuities can help efficiently facilitate generational wealth transfer plans by leveraging three distinguishing features annuities offer: tax-deferral, income control, and diversified investment options. Trustees are empowered with a planning tool that helps them fulfill their fiduciary duties as defined in the trust.
Establishing an Irrevocable Trust
Trusts are generally designed by an attorney to benefit one or both types of the following classes of beneficiaries: the income beneficiaries who may receive the income generated from the trust assets and the remainder beneficiaries who may receive assets in the future.
To illustrate how trust-owned annuities work within an irrevocable trust, we will use a hypothetical married couple, Jeff and Kim Benson. Jeff and Kim’s attorney designed a trust to benefit Kim for her life and pass the remaining assets to their children upon Kim’s passing. They use trust proceeds to fund a $1 million annuity allowing tax deferral to continue through three generations benefiting Jeff and Kim's children and grandchildren1.
Leveraging the Trust-Owned Annuity
In our scenario, several years after establishing the trust, Jeff passes away and Kim meets with her financial professional to discuss the benefits and disadvantages of placing trust assets in taxable and tax-advantaged accounts. The assets are currently in cash, municipal bonds, and exchange-traded funds following the long-term investment objectives of the trust.
The simplest approach for managing the assets would be for the trustee to maintain the current investments. But the market and economic environments are strikingly different today than when the trust was funded initially. The trustee and Kim’s financial professional believe some assets need to be reallocated, although selling certain positions may trigger capital gains tax. Also, if income is retained in the trust, the tax rates that apply to the trust earnings are significantly higher than those of a single filer, and the trust could be exposed to a total tax rate of over 40% on earnings.
Conversely, allocating trust assets to a tax-deferred annuity could be a tax-efficient approach for Kim. Many trusts are eligible for tax deferral under IRC Section 72 (u)2, and during the wealth accumulation phase of the trust's assets, an annuity offers key benefits, which include the ability to:
- Grow assets with tax deferral*
- Turn income on and off3
- Reallocate and rebalance investments within the annuity without triggering taxation4
- Simplify portfolio management5
Accumulating the Legacy
Kim decides to reposition a portion of trust assets into a tax-deferred annuity. The trust stipulates that Kim is entitled to income throughout her lifetime. Kim's financial professional suggests placing $1 million of Jeff and Kim's original $12 million trust assets inside an annuity to take advantage of the annuity's benefits.
Assuming an 8% investment growth rate in the annuity less a 2% fee, and with Kim electing to not take any income from the annuity, the trust-owned annuity assets grow to $1,790,848 after ten years, compared to $1,469,877 had she kept the $1 million invested in a taxable account†. At this time, Kim’s death triggers the next phase of generational wealth transfer.
Passing Down the Benefits
As discussed, many trusts are structured to benefit two types of individuals: those who receive income from the trust — Kim, the original income beneficiary — and those who may receive assets at some point in the future — Kim’s children Daniel, Matt, and Kate. Kim and her financial professional have options on how to title the annuity when it’s opened, each with its own pros and cons.
- Option 1: Standard Titling is Optimal for Providing Liquidity
This potential titling option would be the best choice if Kim's children needed liquidity at their mother's death for expenses like reducing debt, home renovations, and vacations. The annuity death benefit triggers and the trust distributes the money according to the terms, creating a taxable event for the trust, or Kim's children.
- Option 2: Pass-in-Kind Titling is Optimal for Extending Tax-Deferral Benefit
This potential titling option allows for the longest potential period of tax deferral. Upon Kim’s passing, the trustee can, if the trust allows, retitle the annuity from the trust as “owner" to the annuitant (child) as owner, and no taxable event is triggered. What’s more, when each child inherits their own annuity, they can add their spouse as a joint owner and list their children as beneficiaries. If multiple beneficiaries are to inherit annuities following this strategy, then an annuity should be opened for each beneficiary, naming them each individually as an annuitant on their respective annuities6.
Creating a Legacy
When opening the annuity, Kim and her financial professional chose the pass-in-kind option because wealth preservation and growth had always been one of her and her husband’s fundamental goals with the trust. Now, 20 years after Jeff’s death, the original investment of $1 million in the trust owned-annuity has grown to $1,790,848, with Daniel, Matt, and Kate each inheriting individual annuities worth $596,949.
Stretching the Legacy
Ten years later, Kim's oldest child, Daniel, who inherited his annuity via pass-in kind, passes away. Since he never took income from his annuity, the account balance has grown to $1,069,045, which his only daughter, Sophie, inherits as his beneficiary. Sophie has two options to consider for how she will receive the death benefit from the annuity.
- Option 1: Taking the Annuity's Death Benefit as a Lump-Sum or an Out-In-Five Option
With this option, Sophie would receive a lump-sum distribution which could trigger a significant taxable event or select the out-in-five option, which would require the annuity to be entirely liquidated by the end of the fifth year after she inherits it. These are the least tax-efficient options.
- Option 2: Taking the Annuity's Death Benefit as Nonqualified Stretch
With this option, Sophie, now 35 years old, is only required to take a required minimum distribution (RMD) each year based on her life expectancy. This allows the remaining amount to grow on a tax-deferred basis. Sophie selects option 2, and over the ensuing 51 years of her lifetime, she withdraws RMDs of over $6.7 million before taxes and nearly $5.5 million after taxes based on an assumed tax rate of 20%.
A Legacy Fulfilled
As a snapshot of this illustration over three generations, Kim's initial funding of $1 million of trust assets into trust-owned, tax-deferred annuities grew to $1,790,848 after 10 years. Due to the pass-in-kind titling option, Daniel, Matt, and Kate each inherited an annuity worth $596,949 when Kim passed away. Daniel’s annuity grew tax-deferred to $1,069,045 over the next 10 years because he didn't take any distributions.
When Daniel died, his daughter, Sophie, chose the nonqualified stretch method to receive his death benefit, and the pre-tax RMDs she received over the next 51 years of her life amounted to $6,721,620 before taxes and $5,446,302 after taxes.
If the same assumptions and outcomes were applied to Matt and Kate and their children and beneficiaries, the entire pre-tax value of the original $1 million trust-owned annuity would be $20,164,860.
Ready to Put An Annuity to Work for Your Trust-Owned Accounts?
Talk to your financial professional to learn more about what this powerful generational wealth transfer tool can do for you and your extended family. Check out our free eBook for more information.
* Tax deferral offers no additional value if an annuity is used to fund a qualified plan, such as a 401(k) or IRA, and may be found at a lower cost in other investment products. It also may not be available if the annuity is owned by a “legal entity” such as a corporation or certain types of trusts.