Leveraging tax-deferred* annuities in irrevocable trusts

NOVEMBER 4 , 2022


Individuals that wish to transfer assets to children or grandchildren often work with their estate planning attorney or financial professional to develop a plan to meet their objectives. However, executing a plan can be complicated, and estate taxes can take a toll on the couple's accumulated wealth. Learn how trusts and tax-deferred annuities can provide control over legacy assets and potentially protect beneficiaries from creditors.

People of high net worth who intend to transfer assets to their children or grandchildren often work closely with their estate planning attorney and financial professional to develop a plan that allows them to achieve their objectives.

But executing a plan that efficiently transfers generational wealth can be complicated, and estate taxes can take a devastating toll on the wealth a couple has accumulated over a lifetime and hopes to bequeath to their heirs. Trusts are often used in multigenerational estate plans and can provide control over legacy assets, reduce assets exposed to estate taxes, and potentially protect trust beneficiaries from creditors.

 

Multiple Options

Trusts used for estate planning purposes are available in many forms, each carrying certain benefits and limitations. For example,

  • Irrevocable life insurance trusts (ILITs) allow a person to purchase an insurance policy outside of their estate, replacing the assets that may be required to pay estate taxes upon their death. However, there may be little or no upside potential to a life insurance policy's investment cost and the grantors may be uninsurable.
  • Non-grantor trusts come in various forms that can be used for legacy control, estate tax mitigation, special needs planning, or even preserving assets for children from a first marriage. These trusts are subject to higher tax rates than individuals, which can be a drag on the growth of the trust’s assets.
  • A grantor trust can be used to mitigate the high tax rates applicable to trusts (a maximum of 40.8% plus the 3.8% net investment income tax mandated by the Affordable Care Act) generating more than $13,451 of income per year. Taxes due on investment gains in a grantor trust flow back to the granter and are paid at their own individual rates. However, the grantor is now responsible for an additional tax bill on money outside their estate.

 

Trustees' Dilemma

The fact that trustees today are confronting a host of economic and market factors compounds the challenge of using a trust as a wealth transfer strategy and complicates the ability to achieve the trust's defined investment objectives. High inflation, volatile markets, and rapidly rising interest rates have made it increasingly difficult for trustees to ensure trust assets are properly invested. And if a trustee determines a portfolio reallocation is needed, the trust could incur capital gains tax liabilities, and transaction costs.

Trustees carry a heavy burden and may find themselves between a rock and hard place. They are duty bound to both protect the assets in their care to generate income where required, and in many instances grow the trust corpus for the benefit of the remainder beneficiaries of the trust, whose benefits vest at a later time. To represent all beneficiaries equitably, the trust generally must grow at a rate that exceeds inflation in addition to the trust's taxes and fees.

 

The Tax-Deferred Annuity Option

To recap, if the taxes are paid within the trust, the tax rate may be much higher than an individual's tax rate. If the earnings are passed to the individual, they add to the individual's annual tax burden.  And if the trust is a grantor trust, the grantor is now paying taxes on assets they gifted out of their estate. Taxation, and the troublesome manner in which it touches each aspect of an irrevocable trust, is a reason to explore alternatives to taxable accounts for funding a trust.

One such investment is a tax-deferred annuity (TDA) which can be purchased within a trust and allow trust assets to grow on a tax-deferred basis. Some TDAs, known as investment-only variable annuities, are available without riders and guarantees, which can help keep expenses lower. Some of these products can also be purchased as fee-based annuities. Fee-based annuities do not have upfront commissions however the assets are subject to the advisory fee in accordance with the investment advisor's fee schedule which may result in higher or lower fees for the investment.

Other potential advantages of TDAs include:

  • If titled correctly within the trust, the annuity can pass in kind to the remainder beneficiaries, allowing the tax-deferred growth to continue uninterrupted.
  • There are no required annual distributions, which allows all growth within the annuity to remain tax-deferred unless or until withdrawals are taken.
  • If a beneficiary requests earnings to be distributed, the trust would do so via a K-1. This allows earnings to be taxed at the individual's ordinary income tax rate.

 

TDAs in Action

Tax-deferred annuities can provide benefits when used in different irrevocable trusts. For example, when used in a trust to benefit one’s children, the annuity can help avoid trust tax rates altogether and depending on titling, create liquidity for children or allow for multiple generations of tax-deferral. And when used in a special needs trust, a TDA can grow tax-deferred while allowing the trustee to withdraw the exact amount necessary for the person with special needs.

Having an asset that does not create taxation issues within a trust is particularly important for young beneficiaries for whom the grantor wishes to possibly provide support for a long lifetime.

 

Could a Trust Funded by a TDA Help with Your Estate Planning?

Trusts using TDAs can be beneficial for an overall strategic estate plan and can help avoid the trap of higher trust tax rates. Additionally, as a result of their tax-deferral and investment platform (in the case of a variable annuity), the portfolios of these TDAs have the upward potential lacking in more traditional life insurance vehicles with potentially less tax drag than other investments and are more easily managed without concern for tax inefficiency. The money that would have been distributed to avoid trust taxes, or to pay taxes on gains, remains in the trust, which may be the most beneficial outcome for the grantor and their beneficiaries.

Talk to your financial professional to learn more about how irrevocable trusts funded in part by a TDA may be a meaningful approach to consider with your estate plan. Check out our free eBook for more information.

Annuities are long-term, tax-deferred vehicles designed for retirement. Variable annuities involve risk and may lose value. Earnings are taxable as ordinary income when distributed. Individuals may be subject to a 10% additional tax for withdrawals before age 59½ unless an exception to the tax is met.

*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.

Before investing, investors should carefully consider the investment objectives, risks, charges, and expenses of the variable annuity and its underlying investment options. The current contract prospectus and underlying fund prospectuses provide this and other important information. Please contact your financial professional or the Company to obtain the prospectuses. Please read the prospectuses carefully before investing or sending money.

Jackson, its distributors, and their respective representatives do not provide tax, accounting, or legal advice. Any tax statements contained herein were not intended or written to be used and cannot be used for the purpose of avoiding U.S. federal, state, or local tax penalties. Tax laws are complicated and subject to change. Tax results may depend on each taxpayer’s individual set of facts and circumstances. You should rely on your own independent advisors as to any tax, accounting, or legal statements made herein.

The IRS issued a private letter ruling ("PLR") holding that a non-grantor trust cannot use the IRC 72(q) exceptions for (1) reaching age 59 ½, (2) disability, or (3) SEPP payments. The ruling recognized a non-grantor trust may use the IRC 72(q) exception for death. (See PLR 202031008).

Guaranteed lifetime income can be obtained through the purchase of an annuity with an add-on living benefit. Add-on living benefits are available for an extra charge in addition to the ongoing fees and expenses of the annuity and may be subject to conditions and limitations. There is no guarantee that an annuity with an add-on living benefit will provide sufficient supplemental retirement income.

Guarantees are backed by the claims paying ability of the issuing insurance company.

Jackson® is the marketing name for Jackson Financial Inc., Jackson National Life Insurance Company® (Home Office: Lansing, Michigan),  and Jackson National Life Insurance Company of New York® (Home Office: Purchase, New York).