September 09, 2010

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Department of Insurance Contract Structure Traps for Nonqualified Annuities Part 1: Spouses Broker/dealer and agent use only Annuitant Driven Contracts Integrity Life annuity contracts are annuitant-driven. That means that the death benefit is paid out on the death of the ANNUITANT. However, the Internal Revenue Code also makes the death of the OWNER a taxable event. Usually this is not a problem on nonqualified annuities since the owner and annuitant are the same (and never a problem with IRAs since the owner and annuitant must be the same). But tax and contract traps await those who make owner and annuitant different. This can be true even if all the parties on the contract are spouses. We’ve seen lots of cases lately where the clients and reps were surprised by an unexpected outcome when one spouse on the contract died. In this article I will go over some of those unexpected events. Owner’s Beneficiary and Annuitant’s Beneficiary First, I want to explain the owner’s beneficiary v. the annuitant’s beneficiary. An Integrity annuity is a contract promising, among other things, to pay a death benefit to the annuitant’s beneficiary when the annuitant dies. This contract is an asset belonging to the owner (who controls all the distributions). If the annuitant is someone different from the owner, the owner must name an owner’s beneficiary to inherit this asset (i.e., control of the funds and our promise to pay on annuitant’s death) if the owner dies. If the owner and annuitant are the same person, there is usually no need for an owner’s beneficiary. That’s because the annuitant will die at the same time the owner dies, our obligation to pay out to the annuitant’s beneficiary comes to fruition, and the contract ends. Three rules to consider In structuring a contract, use these provisions as a checklist to walk through the possible outcomes if a particular party on the contract dies: IRC Section 72(s): when the OWNER of a contract dies, the OWNER’s BENFICIARY must take a distribution out over life expectancy or five years. However, if the sole primary OWNER’S BENFICIARY is the spouse, the spouse can continue as owner. Also she will become the annuitant unless a third person is already the annuitant. IRC 72(q): There is a 10% penalty on distributions to anyone before age 59 ½. One exception: If the OWNER of the contract died. Integrity Contract provisions: We will pay a death benefit and waive surrender charges if the ANNUITANT dies. If the ANNUITANT dies the ANNUITANT’S BENEFICIARY has to take a lump sum or annuitize. We also have our own interpretation of what happens if an owner dies. Yes, the Owner’s beneficiary, who inherits the contract, will have to pay the 72(s) taxes. But if he does pay them, we will allow the new owner to keep this contract on the life of the annuitant going. If you name the same person as owner and annuitant, the Code and our Contract will line up when that person dies. The results are favorable and unsurprising: Per our contract, we will pay a death benefit and waive surrender charges since the ANNUITANT died. The annuitant’s beneficiary can take a distribution in a lump sum, over life expectancy (per the Contract because the annuitant died), or defer for up to five years (per the Code because the owner died). If the beneficiary is the spouse, we will allow the spouse to continue as new owner and annuitant (it’s a good idea to reinforce this by making spouse both owner’s beneficiary and annuitant’s beneficiary). There will be no 72(q) 10% penalty on the distribution because the OWNER died However, if you put a separate owner and annuitant, you can have unexpected results. Here are 2 cases we see involving spouses where the results are unexpected: Scenario 1: Owner: Wife Owner’s beneficiary: not named Annuitant: Husband Annuitant’s beneficiary: Wife Assume Husband/Annuitant dies first: We will pay out a death benefit (ANNUITANT died) to the wife in a lump sum or over life expectancy (there is no 5-year option because that’s for an OWNER death). Wife can’t continue the contract because the OWNER didn’t die, and spousal continuation is only allowed if the owner dies. Also, if Wife is under 59 ½, she’s subject to the 10% penalty, because the OWNER-Death exception doesn’t apply. Fix: Wife transfers ownership to Husband during life, so that he’s Owner and Annuitant, and wife is Annuitant’s beneficiary (and ideally should be named Owner’s beneficiary). This ownership change is not a taxable event because it involves spouses. Assume Wife/Owner dies first: There is still a contract because the ANNUITANT is still alive. Since wife didn’t name an OWNER’S BENEFICARY, the wife’s estate takes ownership of the contract. 72(s) requires a distribution since the OWNER died. Since the estate owns the contract there is no life expectancy. The only option is deferral up to 5 years. And because the ANNUITANT didn’t die, the distribution is of the Cash Value, not the Death Benefit, and surrender charges are not waived. If the estate pays the tax, it can continue to hold the contract until Husband/annuitant dies. Practically speaking, though, the estate may want to wind up. Fix: Wife could name Husband as Owner’s beneficiary. At wife’s death, Husband could continue the contract as new Owner and Annuitant. He’d have to name a new Annuitant’s beneficiary. Scenario 2: Owners: Husband and Wife Jointly Owner’s beneficiaries: not named Annuitant: Husband Annuitant’s beneficiary: Wife Assume Husband/Joint Owner/Annuitant dies first. Wife as Annuitant’s beneficiary can collect the death benefit without surrender charges. However, she cannot continue the contract because she was not named Husband’s Owner’s Beneficiary. Assume Wife/Joint Owner dies first: Code deems that the death of the first joint owner to be the 72(s) event. Wife’s estate would have to take 72(s) distributions of the cash value over 5 years, and surrender charges are not waived. 72(q) 10% penalty would not apply because the Code deemed that the Owner died. Fix: Husband and Wife should name each other as Owner’s beneficiaries Lessons learned: Spouses should name each other as Owner’s beneficiaries if they want continuation. Note: If the annuitant is neither spouse, such as a child, our contract still ends with Annuitant’s death, even if the spouse is named Owner’s beneficiary. You can eliminate surprises by just keeping it simple: Owner and annuitant are the same person. Stay tuned. Next issue: traps involving children (i.e., non-spouses) and non-natural owners Part 2: Non-Spouses Broker/dealer and agent use only As I said in Part 1, Integrity Life annuity contracts are annuitant-driven. The Internal Revenue Code, which governs the taxation of annuities, seems to assume contracts are owner-driven. This doesn’t cause a problem when the owner and annuitant are the same—the death of the owner is the death of the annuitant, too. But there can be traps if the owner and annuitant are different. Provisions to consider As I said in part 1, keep these provisions in mind if a particular party on the contract dies (I’m omitting spousal continuation—see Part 1 for that): IRC Section 72(s): when the OWNER of a contract dies, the OWNER’S BENFICIARY must take a distribution out over life expectancy or five years. IRC 72(q): There is a 10% penalty on distributions before age 59 ½. One exception: If the OWNER of the contract died. IRC 72(u): When an non-natural owner owns a contract (think corporation, charity, CRT and irrevocable trusts), the contract is not taxed as an annuity. Therefore you lose income tax deferral and gains must be taxed every year. On the up side, there is no 72(q) 10% penalty, because that is a provision on taxing annuities. If this non-natural owner is an agent for a natural person, though, the regular annuity rules apply. A revocable trust is an example of a non-natural person who is an agent for a natural person. Integrity Contract: We will pay a death benefit and waive surrender charges if the ANNUITANT dies. If the ANNUITANT dies the ANNUITANT’S BENEFICIARY has to take a lump sum or annuitize. We also have our own interpretation of what happens if an owner dies. Yes, the OWNER’S BENFICIARY, who inherits the contract, will have to pay the 72(s) taxes. But if he does pay them, we will allow the new owner to keep this contract on the life of the annuitant going. Checklist to avoid problems Here is a checklist to use when the owner and annuitant are different, and no spouses are involved. Run through this checklist twice, assuming that the owner dies first, then assuming that the annuitant dies first: Will Integrity pay a death benefit (Annuitant’s death) or the cash value (Owner’s death)? Will Integrity waive the surrender charge (annuitant’s death)? Will the distribution options be lumps sum + annuitization (annuitant’s death) OR lump sum + annuitization + 5 year deferral (Owner’s death)? Will the recipient of the funds have to pay the 72 (q) 10% penalty if under 59 ½ (annuitant’s death) or is penalty waived (owner’s death or corporate owner)? Pre-death: Will the owner receive income tax deferral (natural persons or trusts for natural persons) or will the owner have to report the gain each year (corporate or charitable owner)? Are you willing to live with those consequences? Sometimes the results are not harmful. For example, You may not care about non-waiver of surrender charges if your client is past the surrender charge period. You may not care about the 10% penalty if your client is over 59 ½. You may not care about a taxable event if there is little or no gain on the contract. 2 structure examples If you put a separate owner and annuitant, you can have unexpected results. Scenario 1: Owner: Mother Owner’s beneficiary: not named Annuitant: Son Annuitant’s beneficiary: Mother or grandchild Assume Mother/Owner dies first: There is still a contract because the annuitant is still alive. If Mother did not name an owner’s beneficiary, contract ownership passes to her estate. 72(s) requires a distribution because the owner died. Since the estate owns the contract there’s no life expectancy, and the only option is lumps sum or deferral up to 5 years. And because the ANNUITANT didn’t die, the distribution is of the Cash Value, not the Death Benefit, and surrender charges are not waived. If the estate pays the tax, it can continue to hold until Son dies. Practically speaking, though, the estate may want to wind up. If it distributes the contract to the heirs under Mother’s will, that could be an additional taxable event (because of transfer of ownership, not because of death). In another scenario, Mother might have named Son or others as Owner’s beneficiaries. They can take over the contract and hold it until the son/annuitant dies, but the 72(s) tax still has to be paid because of Mother’s death. If the Owner’s beneficiaries are under 59 ½, no 10% penalty is due because the OWNER died. Assume Son/Annuitant dies first: We will pay out a death benefit (ANNUITANT died) to the Annuitant’s Beneficiary in a lump sum or over life expectancy (there is no 5-year option because that’s only for an OWNER death). We will waive the surrender charge. If the Annuitant’s Beneficary is under 59 ½, they are subject to the 10% penalty, because the OWNER-Death exception doesn’t apply. Fix: Mother can’t change annuitant. She can give contract to Son so he becomes Owner and Annuitant, but she’d have to pay tax on any gain to date under 72(e). Scenario 2: Owner: Corporation Owner’s beneficiary: not named Annuitant: the Boss Annuitant’s beneficiary: Corporation Since a non-natural person owns the annuity, the corporation will not receive income tax deferral. Each year it will pay income tax on the gain. This will add to its basis, so there may be little or no gain to tax when it takes withdrawals. Since the contract is not taxed as an annuity, there is no 10% penalty for premature distributions. When the boss dies, the corporation can take distributions over five years. The corporation gets the death benefit and surrender charges are waived. Lessons learned: Walk through the checklist to see what will happen if owner or annuitiant dies. Make sure the owner chooses an owner’s beneficiary. This material reflects Integrity Life Insurance Company's understanding of the current federal tax laws and contains information of a general nature. The information provided is not intended to be legal or tax advice. Integrity suggest you or your clients consult a tax advisor or attorney as to the applicability of this material or a specific situation. For more detail on Integrity Life Annuities please contact the Integrity Life Sales desk at 800-666-7040 to obtain a prospectus. Products are issued by Integrity Life Insurance Company, Cincinnati, Ohio. Products sold in New York, Vermont and New Hampshire are issued by National Integrity Life Insurance Company, Goshen, NY. All products distributed by Touchstone Securities, Inc. Cincinnati, OH member NASD/SIPC.

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