Financial advisors who work with individuals in the 50-plus crowd deal with it every day: people who fear their money will run out. Clients are growing more aware of planning missteps and becoming concerned with the threat of outliving their retirement savings. Insurers in turn, as they have for generations, are issuing annuities with the security of a guaranteed income for life. For those who want to guarantee their money will be used to help their favorite cause, annuities can be used to fund charitable trusts.
What about clients who want to use an annuity to leave something behind for their heirs? You may want to examine the legacy options for beneficiaries of a non-qualified annuity. A non-qualified annuity is funded with after-tax dollars and provides opportunities for tax-advantaged savings and a guarantee of principal. It also can be designed to allow the contract owner's spouse or non-spousal beneficiaries to preserve the annuity as a tax-deferred account. Learn the capabilities of a non-qualified annuity, specifically by using beneficiary designation forms to take advantage of certain Internal Revenue Code rules, and you can enhance your value as an advisor.
Annuity solution that's a real stretch
Recall that one of the first things you're taught in gym class is the value of stretching before you exercise. Whether it's before an intense game of fifth-grade dodgeball or a competitive marathon, proper stretching technique is essential to go the distance.
For clients who want an annuity's legacy option to be as effective as possible, you may want to recommend stretching of a different kind. Beneficiaries can be provided with a lifetime income stream when the distributions from a non-qualified annuity are "stretched out" over the beneficiaries' lifetime, creating what's known as a non-qualified stretch annuity.
This particular annuity takes advantage of the one-year rule in Internal Revenue Code Section 72(s). Its name comes from the requirement that non-lump-sum distributions from the annuity must begin no later than one year following the death of the annuity owner. However, the stretching must be elected within 60 days after the death benefit is payable. The rule's advantage is that it saves the non-qualified annuity's tax-deferral features for the beneficiaries while avoiding the early taxation of annuity benefits and values. Two stretching methods are allowed with the one-year rule. The annuity assets either can be distributed over the lifetime of the beneficiary or annuitized.
Say the beneficiary wants to stretch annuity payments over his lifetime. This requires determining a distribution amount by dividing the annuity account balance at the end of the previous year by the beneficiary's life expectancy (determined by a Treasury Regulation Table). For a 35-year-old beneficiary, for example, the account balance of the annuity would be divided by 47.3 for the first year's distributed amount. After that first year, the account balance would be divided by a number that's one less (46.3 for the second year).
Distribution periods on annuities with multiple named beneficiaries will be determined using the beneficiary with the shortest life expectancy. Alternatively, the annuity can be divided into separate shares for each beneficiary, with each share stretched according to the particular beneficiary's life expectancy. A beneficiary may elect to take distributions more rapidly or in a larger amount than determined under the above method – unless the owner has restricted the beneficiary's right to do so.
Some beneficiaries may choose to have non-qualified annuity distributions stretched by annuitizing the contract within one year of the owner's death. This leaves them with a number of options: a life annuity, a life annuity with a period-certain guarantee or customizing distribution over a designated period. Depending on the age of the beneficiary, the annuity issuer may require that the term of years be reduced to the term permitted (the life expectancy of the beneficiary) per Treasury Regulations and the Internal Revenue Code.
The five-year alternative
Any non-qualified annuity that doesn't take advantage of the one-year rule defaults to what is known as the five-year rule of Internal Revenue Code Section 72(s). This alternative requires that the entire value of the annuity contract be distributed within five years after the death of the contract owner. A benefit is that the annuity continues growing tax-deferred for up to five years after the owner's death. A drawback is that the annuity must be distributed – and any gain taxed to the beneficiaries – at some point within that five-year period.
There are certain instances where the five-year rule is mandated. These include when the annuity owner dies before the starting date and no beneficiaries are designated, or when a trust, corporation or partnership is named as beneficiary instead of an individual. From a beneficiary's perspective, the five-year rule may be more appealing than stretching the distributions.
Is stretching worth it?
Let's consider the advantages of stretching an annuity distribution versus selecting the five-year rule or a lump-sum payment. The following tables feature examples showing the possible alternatives available for distribution of non-qualified annuity values at the death of the annuity owner.
Let's use Mary's annuity as an example. Mary purchased a non-qualified annuity 20 years ago with an initial investment of $250,000. Mary named her daughter, Joan, now age 35, as the annuity beneficiary.
At Mary's death, Joan can select one of four methods for taking distribution of her mother's annuity value, three of which are illustrated below. All examples shown assume that Mary's estate is not subject to federal or state estate tax.
- Mary's investment in her non-qualified annuity: $250,000
- Net average annual return: 8 percent (after any M&E; or fund expenses)
- Current value of Mary's annuity: $1,165,239
Lump-sum distribution
Joan could elect to take a distribution of Mary's entire annuity value at the time of Mary's death. We will assume that Joan is in the 35 percent income tax bracket:
- Annuity value: $1,165,239 ($250,000 initial investment earning net 8 percent return)
- Taxable amount: $915,239 ($1,165,239 minus $250,000 initial investment)
- Taxes owed: $320,334 ($915,239 x 35 percent)
- Joan's net benefit: $844,905
Distribution at end of the five-year period
