Last week, I wrote about the pros and cons of buying an annuity. Given the complex nature of annuities, I thought it was important to also cover potential complex mistakes that people make regarding them.
First, annuity contracts can be either owner-driven or annuitant-driven. This is not a commonly known distinction. The owner of the contract is the person who bought and controls it, pays the premiums, makes withdrawals, etc., whereas the annuitant is the person whose life the contract benefits are based on. In an annuitant-driven annuity, the contract ceases upon the death of the annuitant. For owner-driven contracts, it’s the death of the owner that causes the annuity to terminate. The vast majority of annuity contracts are owner-driven. Who cares about the difference? Well, it becomes important as we see when changes (and potentially mistakes) are made to the contracts. Here are some potential mistakes:
1. Changing the owner of a non-IRA annuity to anyone but your spouse
Let’s say you were the owner of an annuity, and your sibling was the annuitant. If you wanted to transfer ownership to them, this would be considered a taxable event. Worse, it is taxable to you, the owner. The same goes for later adding them as an owner to the contract. The only time it doesn’t create a taxable event is when a spouse or revocable grantor trust is added.
2. Using a non-IRA annuity as collateral for a loan
Often, loan companies want collateral for the loans they provide. Using a non-IRA for that collateral or assigning it to someone creates a taxable event. Worse, if you are younger than 59 ½, you are subject to the 10% penalty as well.
3. Naming a minor as the beneficiary of an annuity
A minor cannot own legal property, so leaving your annuity to a minor could cause guardianship issues (particularly if the parents later divorce). Courts can decide who the guardian of the property would be, and it might not be the person you would have chosen for yourself.
4. Transferring an annuity to a revocable living trust without reason
Unless your attorney has specific reasons for wanting you to transfer an annuity to a revocable living trust, there is no need to do so. Annuities are already tax-deferred and not subject to probate, and since they pass via a named beneficiary, there really is no need to have one inside the revocable living trust.
5. Ignoring partial distribution rules
If you exchange a portion of an annuity for another annuity, you can not take a distribution from either annuity for 180 days. This applies only to partial distributions from an annuity. If you take a distribution within 180 days, the IRS will deem the distribution to be a part of the original exchange. The purpose of this rule is to avoid potential abuse. The IRS doesn’t want you to try to split the gain from the cost basis of an annuity contract into a new contract and then try to take out funds from the contract with no gain. All cost basis would be prorated between the 2 contracts. The exception to this rule is if you annuitize the contract over a period of more than 10 years.
6. Making a gift of an annuity to a charity
This gift is a taxable event. While the gift is tax-deductible, since it is a non-cash gift, the deduction is limited.
7. Naming an estate as the beneficiary of an annuity
Naming your estate as the beneficiary of a non-IRA annuity makes a normally non-probate asset subject to probate. This will cost both time and money. This also makes it subject to creditors.
Annuities for the right client can be great, but making mistakes once you own it can cost you or your heirs a lot of unnecessary expenses and headaches. Make sure you seek competent legal and financial counsel before making any changes to them.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. To view form CRS visit https://bit.ly/KF-Disclosures.
Eric is President and founder of Reich Asset Management, LLC. He relies on his 25 years of experience to help clients have an enjoyable retirement. He is a Certified Financial Planner™ and Certified Investment Management AnalystSM (CIMA®) and has earned his Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®) designations.
