Deferred annuity trusts

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.

Tax-deferred growth is an excellent way to build wealth over time. Trusts are a great way to safeguard that wealth and to ensure its proper use. In the rare instance when the two can be combined, an ideal strategy to help provide for a child's or grandchild's retirement can be realized. Such is the case when a deferred annuity is combined with a trust. This article will give a general overview of how a deferred annuity trust (DAT) works. But first, the alternatives to a DAT and why they fall short will be examined.

One of the best vehicles for tax-deferred growth is an IRA. However, contributions to IRAs are limited (or impossible, if a child has no earned income). That is a negative. In addition, though not a problem from a creditor protection standpoint, the fact that IRAs cannot be owned by trusts removes a significant method of safeguarding against an early cash-out from the picture. For these reasons, IRAs fall short of the ideal.

On the other hand, IRC Section 529 accounts (529s) can be owned by trusts with no negative consequences. These plans can also grow income tax free. However, if 529 withdrawals are not used for education, a 10 percent penalty on top of an income tax will apply. Assuming that pursuing further education in their retirement years is not at the top of most retirees' lists(laudable as it may be), the penalty and income tax for non-education 529 expenditures present an enormous negative. For this reason, 529s also fall short of the ideal.

That leaves deferred annuities. These also grow tax-deferred, and they can be held by trusts without negative consequences as long as the trust qualifies as an agent for a natural person. See my ProducersWeb article, "Trust-owned annuities", for tips on how to design a trust to so qualify. As with IRAs, trust ownership lends assistance only in safeguarding against an early cash-out, since deferred annuities are generally protected from creditors on their own. However, since trust ownership is possible, the same safeguarding can be implemented. For these reasons, trust-owned deferred annuities fit the bill.

The table below summarizes the comparison.

Unlimited contributions?NoNo*Yes
Suitable for retirement?YesNoYes
*Rules vary from state to state.

How a DAT works

First, a parent, grandparent, aunt, uncle -- anyone, really -- establishes and funds an irrevocable trust for a child, grandchild, niece, nephew, etc. No gift tax will be due on transfers to the DAT, since most transfers will not exceed the donor's annual gift tax exclusion (currently $13,000, and assuming the DAT has so-called "Crummey" powers [The use of Crummey powers allows a parent to make gifts to an irrevocable trust that can qualify for the tax free annual exclusion]); or the donor's gift tax credit (relevant if the DAT has "Crummey" powers, but the transfer exceeds the annual gift tax exclusion, or, if the DAT does not have "Crummey" powers). The DAT trustee then purchases a deferred annuity in the name of the trust. The trust would also be the beneficiary of the contract. The beneficiary of the trust would be the annuitant. While the terms and conditions under which the beneficiary could receive DAT distributions could vary as widely as the donor's imagination allows, a simple and straight-forward program would require that, unless the DAT beneficiary meets the disability exception to the IRC Section 72(t) penalty -- in which case assistance from the DAT would be allowed -- no distributions from the DAT would occur prior to the trust's termination when the beneficiary attains a specified age (typically age 65). Upon termination, the DAT trustee would transfer the annuity to the beneficiary and then close the trust.

Let's look at an example. Looking far into the future, and though concerned about their own financial needs, Michael and Barbara nonetheless desire to set aside a long-term fund to provide for their five-year-old granddaughter Hannah's retirement. They create a DAT and fund it with a one-time gift of $26,000. The deferred annuity acquired shortly thereafter by the DAT earns 6 percent per year until trust termination when Hannah reaches age 65. At that time, the annuity -- which is worth slightly more than $850,000 -- is distributed to Hannah without any tax ramifications. Hannah must then decide how much or little to withdraw from the annuity to meet or supplement her retirement needs, as well as if and when to annuitize the contract. However those decisions may come out, Hannah, who might not have even known about the DAT's existence prior to receiving the annuity, will certainly look back upon her then long-deceased grandparents' foresight with grateful affection.

The next time your clients inquire about ways to help their children and grandchildren save for retirement, be sure to include the DAT on your list of alternatives. It could just be the ideal way to go. But, keep in mind that annuities are not for everyone, and are fraught with complications, particularly when they are owned by a trust. Annuities must be suitable to your client's particular facts and circumstances. For an excellent article on suitability, see "Suitability 101" by Bob Seawright, Executive Business Partner, Asset Marketing Systems, and one of the expert columnists for ProducersWeb.

The author would like to acknowledge the significant contributions made by his partner, Salvatore J. LaMendola, J.D., in the preparation of this article.


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