In Brief

America is currently undergoing the largest wealth transfer in its history, as Baby Boomers begin to enter retirement and make provisions for their heirs. Given the higher tax rates recently enacted, the pitfalls of such arrangements abound, but many can be avoided through the use of tax-deferred annuities. The authors discuss the growing use of annuities to not only reduce and defer taxation but also as estate planning vehicles.

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This article will discuss current trends regarding the evolving role of tax-deferred annuities (TDA) and their use by investors to potentially reduce taxes—or at least control when taxable distributions are taken. It will also discuss the use of annuities as estate planning vehicles, especially for irrevocable trusts, which have been disproportionately impacted by recent changes in the markets and tax code.

1. How Are TDAs Structured?

Annuities are generally either immediate or deferred. In immediate annuities, the customer pays a lump sum to an insurance company in exchange for an income stream, usually paid over the life expectancy of one or more individuals. Because immediate annuities convert an asset into an income stream, they are often used for Medicaid or general creditor protection planning. Deferred annuities, by contrast, allow the individual to retain ownership and control of the asset, which provides for income payments at some time in the future. Therefore, these are often used to create non–ERISA-qualified retirement accounts, where the investment can accumulate value on a tax-deferred basis without the plan contribution limits, age limits, or required distributions of an ERISA-qualified account. In addition, taking distributions when the owner is no longer working may lower the owner’s tax bracket.

TDAs are an investment contract sold by an insurance company wherein the contract owner can invest in sub-accounts within the annuity. For insurance companies, these are pooled investment funds that typically invest in a variety of different underlying investments and have no required annual capital distributions. For tax reporting purposes, when the owner withdraws a distribution from an annuity, a portion is taxed as ordinary income to the extent that the distribution represents investment gain and the balance as a non-taxable return of the original investment.

These pooled investment funds typically invest in a variety of different underlying investments and have no required annual capital distributions.

2. What Benefits Do TDAs Offer in Light of Recent Tax Legislation?

One of the major funding sources in the Affordable Care Act of 2010 (ACA) is the 3.8% net investment income tax (NIIT, or Medicare surtax), applicable to taxpayers with modified adjusted gross incomes of $200,000 (single filers) or $250,000 (joint filers) (29 USC 1411). These MAGI thresholds impact taxpayers many would not consider high earners. Furthermore, because those MAGI thresholds are not indexed for inflation, the surtax will impact more investors over time.

The American Taxpayer Relief Act of 2012 (ATRA) raised the maximum marginal income tax bracket to 39.6% and the maximum capital gains tax rate to 20%. In addition, it reinstituted the phase-outs of itemized deductions and personal exemptions, effectively raising rates for affected taxpayers. Those taxpayers could benefit from a TDA by removing investment income from their AGI, perhaps preserving deductions or exemptions.

The ATRA also permanently indexed the Internal Revenue Code (IRC) section 55 alternative minimum tax (AMT) exemption thresholds (up to $186,300 at 26% and 28% on any amounts above that for 2016 joint filers), both rates being higher than the rates applicable to long-term capital gains. Taxpayers affected by this provision could also benefit from a TDA, where any growth inside the contract would not be included in AGI, deferring or perhaps avoiding AMT.

3. Which Taxpayers Can Benefit Most?

Investors currently in the top three income tax brackets, subject to the NIIT, and currently recognizing more taxable investment income than they need will benefit most from a TDA. TDA investors benefit by allowing their investments to grow tax-deferred while they are working and then taking distributions in later years, when they no longer have earned income and are in the top tax brackets (such as might be applicable when unneeded dividend or capital gain distributions are made from mutual funds).

In the past, high earners sometimes eschewed TDAs in favor of capital assets because the taxable portion of distributions from an appreciated TDA is taxed as ordinary income and not capital gain. The 3.8% surtax added by the ACA, however, causes preferential items such as qualified dividends and capital gains to now be taxed between 18.8% and 23.8%, which is closer to the 15% and 28% rates applicable to many taxpayers in retirement.

4. Can Tax-Deferred Status Continue after the Death of the Owner?

The beneficiary of a death benefit on a TDA has three options under IRC section 72(s): 1) collect a lump sum, with any tax-deferred growth taxable; 2) annuitize the death benefit over the beneficiary’s life expectancy, applying the exclusion ratio to recover the original owner’s basis on a pro rata basis; or 3) take a five-year settlement with no required distributions during the period, but with the entire amount required to be taken by the end of the fifth year.

There is also the widely utilized Private Letter Ruling (PLR) 200151038, which allows the beneficiary of an annuity death benefit to elect to stretch the benefit amount over her own life expectancy. A beneficiary electing this stretch option must take an IRS Table I required minimum distribution (RMD) each year, but the remainder can stay invested, with any growth accumulating tax-deferred.

5. How Have TDAs Evolved?

The TDA was originally conceived as a nonqualified, tax-deferred investment vehicle for retirement assets. Over the last two decades, insurance companies have offered investment guarantees, allowing the purchasers of guaranteed TDAs to transfer investment risk to the issuing company. Due to this risk transfer, the guarantees often carry relatively high fees, restricted investment choices, and limited liquidity. More recently, a few companies have begun offering what the industry calls investment-only variable annuities (IOVA), which have no built-in guarantees, higher risk/return investment options, and lower fees.

6. Can the TDA Be Transferred to Another Insurer after the Owner’s Death?

The original owner of a TDA can transfer it from one insurance carrier to another without incurring a taxable event via an IRC section 1035 transfer. Pursuant to PLR 201330016, most insurance companies have also begun allowing tax-free transfers of the death benefit on TDAs so long as the transfer is initiated and completed within one year of the original owner’s death. This allows transfers to a TDA a continued stretch of distributions, carries lower costs, or has more appropriate subaccount investment options. This can be particularly useful for beneficiaries who inherit in their high-earning years or have limited growth potential in the original TDA. In addition, guarantees on TDAs expire at the original owner’s death, but the fees do not; beneficiaries may thus wish to transfer to an IOVA or other TDA.

7. Are TDAs Appropriate for Minors?

TDAs are afforded tax deferral because they are designed as retirement assets. Therefore, IRC section 72(q) imposes an additional 10% tax for distributions of any portion of gain taken before age 59½, making them generally inappropriate for minors. For an immediate annuity purchased with a single premium and periodic payment distributions beginning in less than one year, however, the additional 10% tax does not apply. These single premium immediate annuities (SPIA) are commonly used in legal settlements, including ones involving minors. In addition, TDAs are currently excluded from reporting for federal financial aid purposes on the Free Application for Federal Student Aid (FAFSA) form.

Companies have begun offering investment-only variable annuities, which have no built-in guarantees, higher risk/return investment options, and lower fees.

8. Is It Appropriate to Invest in a TDA within an IRA?

Because traditional individual retirement accounts (IRA) are already tax-deferred, using a TDA is redundant for income tax purposes. There may, however, be other reasons for such an investment. For IRA investors and surviving spouses who must receive a certain amount from their IRA, the guaranteed annual returns and death benefit values of TDAs may be appealing. Moreover, IOVAs may provide the IRA owner access to alternative investments such as managed futures or private equity. Alternative investing involves allocating a portion of a portfolio to nontraditional investments in order to reduce portfolio volatility. Reducing volatility is particularly important after the IRA owner turns 70½ and must begin distributions. If those distributions must be made after one year of negative growth, that IRA account will deplete quickly. A TDA could be used in a Roth IRA for the same reasons.

9. Can an Entity Own a TDA?

Because TDAs were conceived as retirement accounts, the general rule under IRC section 72 provides tax deferral only to “natural persons” who own TDAs. The only exception is under section 72 (u)(1); when an irrevocable trust owns a TDA, tax deferral can be provided so long as the trust beneficiaries are all natural persons.

10. Have the ATRA and ACA Affected Investments Held by Non-Grantor Trusts?

Non-grantor trusts are separate taxpaying entities for income tax purposes. The income tax brackets applicable to them, however, are very compressed, with only $12,400 of retained income needed to reach the 39.6% bracket. Because the ACA applies the Medicare surtax to that top tax bracket, these trusts now face income tax rates of 43.4% on short-term capital gains, interest, and ordinary dividends, and 23.8% on long-term capital gains and qualified dividends. Most non-grantor trusts are funded to place future growth outside of the grantor’s taxable estate for estate tax purposes; however, these trusts often find it difficult to grow the value of the trust corpus because retained income is so heavily taxed. Moreover, the fiduciary accounting rules applicable to irrevocable trusts, unless opted out of, consider capital gains to be principal added to the trust corpus. Consequently, when capital gains are added to principal, trust tax rates apply.

The fiduciary accounting rules applicable to irrevocable trusts, unless opted out of, consider capital gains to be principal added to the trust corpus.

11. Would Naming a Trust as the Beneficiary of an IRA Containing a TDA Offer Any Benefits?

In Clark v. Rameker [134 S.Ct. 2242 (2014)], the Supreme Court unanimously decided that there is no creditor protection under federal law for a beneficiary with respect to retirement funds. Therefore, most advisors are now counseling clients with either significant amounts of qualified money or beneficiaries who have some potential creditor issues to establish an irrevocable trust, with appropriate spendthrift provisions, as the beneficiary of their qualified funds. This trust could then provide creditor protection on the qualified money to ensure that the assets remain within the family after the original owner’s death.

Many clients are now reaching their 70s with substantial IRAs and no need to take the mandatory distributions. These IRAs can be a real tax bomb to such investors, because IRAs usually represent pretax dollars taxed as ordinary income. Moreover, the IRA must be distributed over the lifetimes of the owner, spouse, and their beneficiaries.

Furthermore, because beneficiaries often inherit when they are in their high-earning years, they often elect a stretch distribution strategy, as discussed above. If an irrevocable trust is named the beneficiary of the IRA, the ability to stretch the IRA within the trust is preserved so long as the basic requirements within IRS Publication 590-B are fulfilled. Unfortunately, very few IRA custodians will provide stretch distributions through a trust. Some insurance companies that offer TDAs, however, will do so.

12. Are TDAs Subject to Estate Tax?

Although TDA owners can defer the income tax on investment growth each year, the estate tax is still applicable upon death, as the tax-deferred growth is considered income in respect of decedents (IRD) under IRC section 691. For any amount of tax-deferred growth on which estate tax is paid, however, the beneficiary who receives it can take an income tax deduction for distributions taken and thereby avoid paying income tax on assets for which estate tax was paid.

13. How Can Taxpayers Maximize the IRD Deduction?

In addition to creditor protection, making an irrevocable trust the owner of an inherited IRA can provide another important estate tax benefit. With inherited IRAs on which estate tax has been paid, the beneficiary would normally have an income tax deduction for the amount of estate tax that was incurred [IRC section 691(c)]. If those beneficiaries have adjusted gross incomes—including any required RMDs—over $331,300 in 2016 for joint filers; $259,400 for single filers—the phaseout of itemized deductions means that they will not be able to take the IRD deduction and therefore will pay an effective double tax on RMDs.

When an irrevocable trust is the owner of an inherited IRA, however, IRC section 68(e) provides that those deduction phase-outs do not apply. The trust could utilize all of the IRD deduction to help the family avoid having to pay tax twice on the IRA (if the trust accumulates RMDs). The trustee may even consider liquidating a portion of the IRA, at least to the extent of the IRD deduction, in order to reinvest the proceeds in a nonqualified TDA. This transforms the IRA into an investment that can actually accumulate value, and any future growth will not be part of the taxable estate.

14. Can a TDA Benefit a Bypass Trust?

In the typical bypass trust scenario, a deceased spouse’s estate funds an irrevocable testamentary trust, utilizing the decedent’s available unified credit. Because all future growth in that trust is outside of a taxable estate, the trustee often advises the income beneficiary/surviving spouse to spend down his taxable estate before taking distributions from the bypass trust. Many advisors would counsel against the trust paying extra trust tax preparation fees, and possibly administration and management fees, if it is merely reinvesting the growth into the surviving spouse’s taxable estate. Nonetheless, this occurs routinely; irrevocable trusts with taxable income will distribute those amounts to income beneficiaries in order to have the beneficiaries pay taxes at individual tax rates.

In contrast, the growth of a TDA is taxed only to the extent it is removed from the TDA. The TDA also gives trustees a tax-efficient portfolio rebalancing tool, which can be helpful in meeting prudent investor standards. In essence, investments can be rebalanced without a taxable event—a significant benefit given the compressed trust tax brackets.

15. Can a TDA Be Distributed In-Kind from a Non-Grantor Trust?

TDAs also give trustees some unique retitling options to facilitate tax-efficient distribution strategies for the pre-tax growth accumulated while held by the trust. PLR 199905015 gave the insurance industry the ability to retitle an annuity from trust ownership to a remainder beneficiary without creating a taxable event or any distribution requirements. A non-grantor trust (such as a bypass trust) therefore could accumulate pre-tax growth as long as it owns the annuity, and that remainder beneficiary could continue to accumulate pre-tax growth for the rest of the individual’s life. When that individual dies, the named beneficiary on the TDA can make an election of a “distribution in accordance with the life expectancy fraction method,” or, as referred to in the insurance industry, a nonqualified stretch (PLR 200151038). This distribution method essentially treats the nonqualified annuity death benefit as an inherited IRA (i.e., required to take Table I RMDs, with the balance growing tax-deferred during this individual’s lifetime).

16. How Can a TDA Benefit from a GST or Dynasty Trust?

Generation-skipping trusts (GST) and dynasty trusts are funded utilizing a grantor’s GST exemption, with the remainder beneficiaries being individuals 37½ years or younger than the grantor. As with estate taxes, the income beneficiaries often do not need the distributions, which would otherwise increase the size of their taxable estates and waste the GST exemption. Alternatively, a trustee in this situation could invest into a TDA in order to control the amounts of taxable income and accumulated growth each year. Due to the protracted nature of the final trust distributions to remainder beneficiaries, there is a significant opportunity for GST and dynasty trusts to accumulate growth utilizing TDAs.

PLR 199905015 gave the insurance industry the ability to retitle an annuity from trust ownership to a remainder beneficiary without creating a taxable event or any distribution requirements.

17. Can a Special Needs Trust Benefit from a TDA?

Many people transfer funds to individuals with debilitating personal conditions. Often, the donor makes a gift to a special needs trust (SNT) for that individual’s benefit; the terms of that trust instruct the trustee to use its assets to purchase goods and services that enhance that person’s lifestyle, but not to make distributions directly to that person. The goal is to allow the beneficiary to qualify for public assistance to meet the individual’s basic necessities.

Because the grantor never knows for certain the beneficiary’s life expectancy, the progress of the condition, or how much public assistance will be available, he often makes the gift to ensure that there are more than enough trust funds available to care for that person for life. Therefore, the trust may produce more growth each year than the trustee can use for the beneficiary’s benefit, and any surplus may be subject to the confiscatory trust tax rates. A TDA could be used as an investment vehicle for the SNT to provide broad diversification while generating tax-deferred growth that could yield a significant remainder interest.

18. Can a Charitable Remainder Trust Benefit from a TDA?

IRC section 664 charitable remainder trusts (CRT) are tax exempt, so the tax deferral of TDAs provides no tax benefit. IOVAs, however, may provide access to nontraditional investments that the trust may not be able access elsewhere. This can be important, since CRTs must distribute a net amount of 5% or more every year, and if traditional investments produce no growth in a down year, the trustee will have to use principal.

A special variant of CRTs called a net income makeup charitable remainder uni-trust (NIMCRUT) is designed to intentionally accumulate tax-deferred growth for a period and then begin making payments after a triggering event (Treasury Regulations section 1.664-3). These trusts are often used to liquidate low-basis, highly appreciated assets that represent a concentration risk for the owner. A common example is a business owner contemplating selling her business and receiving consideration that could include a five-year compensated consulting agreement. With this 60-month flow of income, that prospective seller faces higher capital gains rates that could question the feasibility of selling the business.

Some creative planners use NIMCRUTs to provide clients facing this situation the option to essentially convert the business into a pension beginning on the 61st month. The owner donates the business interest/assets to a NIMCRUT (with a triggering event for “retirement”) prior to formal negotiations for the contemplated sale. The trustee sells the assets without any income tax being incurred. These pretax proceeds are used for investments that are expected to appreciate in value during the deferral period (such as small cap stocks) but that produce no income to be distributed to the donor-trust beneficiary during the period encompassing the receipt of the postdisposition consulting compensation.

Many advisors would legitimately question whether a donor who selects the NIMCRUT strategy is effectively diversifying from a small business. For this reason, planners now advocate investing in a TDA because it may provide no distributable income each year, but the trust portfolio can be more broadly diversified with subaccounts.

19. Can a TDA Be Used in an Intentionally Defective Grantor Trust?

An intentionally defective grantor trust (IDGT) is effective for transfer tax purposes, similar to a non-grantor trust, but defective for income tax purposes, as the grantor remains responsible for paying income taxes on investments when a Form 1099 or Form K-1 is issued to the trust. If the grantor has exhausted the lifetime unified credit and is paying tax on investment growth annually on the assets that will eventually be distributed to the beneficiaries, he is effectively making additional gifts without paying gift tax. The ATRA has significantly changed transfer taxes, providing a unified credit that shelters an individual’s estate of up to $5.45 million (in 2016) with a top transfer tax rate of 40%.

Recall that the top income tax rate has increased significantly to 43.4% (including the NIIT). As a result, the ATRA has a bias toward increased income taxes and decreased transfer taxes. In addition, market volatility means that many diversified portfolios are producing significant short-term capital gains and ordinary dividends. As an alternative to paying ordinary income tax on these gains, the trustee of an IDGT could invest in a TDA and thereby effectively retain the ability to generate growth in the trust while reducing the grantor’s income tax burden. Under this strategy, trust beneficiaries may receive more net assets than under the current ATRA rates.

20. Can a TDA Help When Qualifying for Medicaid or Protecting from Creditors?

Although Medicaid is a federal program, states are allowed to write qualification rules for their residents. The rules qualify residents based on assets (resources), income, or a combination of the two. Through the purchase of a “Medicaid conforming” immediate annuity, asset owners may convert assets into an income stream paid over a period of years up to the owner’s life expectancy [Health Care Financing Administration (HFCA), State Medicaid Manual, section 3258.9 (HCFA Transmittal No. 64)]. This annuitization can remove the asset from the owner’s Medicaid resource calculation.

For example, Bob is about to enter a nursing home, and his family would like to qualify him for Medicaid while avoiding having to liquidate all of his and his wife Debra’s nonexempt assets to pay for his care. In order to reduce their assets under their state’s maximum Medicaid asset ceiling, Debra purchases an immediate annuity with a maximum annuitization period of Bob’s life expectancy. To help ameliorate the impact of dying before receiving all the income payments, most companies offer a policy rider that ensures continued payments to successor beneficiaries for a set “period certain.” Annuitization may be beneficial for residents of states where assets are a larger part of the Medicaid qualification formula.

Creditor protection under federal law is limited to annuitized payments “payable by reason of illness, disability, death, age, or length of service to the extent reasonably necessary for the debtor’s support” [11 USC 522(d)(10)(E)]. Many states view TDAs as retirement assets and therefore at least partially exempt from creditor claims, but protection varies widely. A complete list can be found at

Peter A. Karl, JD, CPA is a partner with Paravati, Karl, Green & DeBella, LLP in Utica, N.Y., and a professor of law and taxation at the SUNY Polytechnic Institute (Utica-Rome). He is a member of The CPA Journal Editorial Board.
Kurt Kauffman, JD, LLM (Tax) is director of the retirement & wealth strategies department at Jackson National Life Distributors LLC, Denver, Colo.