An annuity is one way to save for retirement that offers some tax advantages that differ from commonly used retirement accounts, such as an IRA or an employer-sponsored 401(k). The primary tax benefit of an annuity is that your account earnings are tax deferred -- that is, you do not pay income tax on the earnings until you take a distribution. However, the tax rules for annuities also include disadvantages, particularly if you use a trust as part of your retirement planning. Depending on the type of trust involved, annuity transfers into or out of a trust may be taxable.
Know Which Tax Rules Apply
Tax rules differ for retirement accounts depending on whether the account is part of a qualified or nonqualified plan. Examples of qualified retirement plans include IRAs and 401(k) plans. Annuities can be part of a qualified retirement plan, or they can be a separate nonqualified retirement plan. If your annuity is part of your qualified retirement plan, the tax rules for qualified plans apply to your annuity. For example, if your annuity is part of your IRA account, transferring ownership of the annuity to a trust will result in adverse tax consequences because the IRS prohibits a non-individual from owning an IRA. Similar IRS rules apply to funds held in an employer-sponsored qualified retirement plan, which are solely for the exclusive benefit of the individual employees or their beneficiaries.
Your annuity is nonqualified if you purchased it with after-tax dollars -- that is, you did not take a tax deduction for the purchase as you can for an IRA contribution. Also, such an annuity will not be part of an employer-sponsored retirement plan. You can purchase and contribute to a nonqualified annuity as an individual or through a trust. The IRS does not impose contribution limits on nonqualified annuities, nor does it require the use of earned income to contribute to the annuity. Although your state may impose mandatory withdrawal rules for your nonqualified annuity, the IRS does not.
As a general rule, transferring ownership of a nonqualified annuity to another person or entity does have tax consequences, regardless of whether the annuity is held in a trust or not. The annuity earnings are subject to tax when transferred, and if the transfer is made before age 59½, a 10 percent penalty may apply for early withdrawal. However, exceptions to the general rule apply for transfers between spouses due to divorce and between an individual and her grantor trust. A common type of grantor trust is a living trust used for estate planning purposes. The word "grantor" refers to the person who establishes the trust.
Transferring ownership of a nonqualified annuity to or from a trust should not be done without professional advice. Although such transfers can fall under a tax exception, other factors may cause a taxable event. For example, gift tax rules may apply to the transfer. Also, if the trust is not a grantor trust, other IRS rules may apply that cause the transfer to be a taxable event. A tax expert specializing in handling retirement funds should be consulted to analyze your specific situation.
- Woodmen of the World: Nonqualified Annuities -- Saving Without Limits
- IRS: Publication 590 -- Individual Retirement Arrangements (IRAs)
- Heritage Law Center: Should I Put my IRA in a Trust?
- IRS: A Guide to Common Qualified Plan Requirements
- Immediate Annuities: Non-Qualified Annuity Tax Rule
- Kitces: Owning Deferred Annuities In Trusts And Preserving Tax-Deferral Treatment
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