An owner of a nonqualified annuity has options. An annuity is nonqualified if you buy it directly from the issuer in a taxable account. Qualified annuities reside in tax-sheltered employer plans and individual retirement accounts. The owner of a nonqualified annuity doesn't have to be the annuitant. A qualified annuity can receive a new owner through a sale, gift or bequest.
Ownership-Driven vs. Annuitant-Driven Annuities
The owner of an annuity normally pays the premiums and receives the annuity payments. The annuity pays death benefits to the policy beneficiary. In an owner-driven annuity, the death of the annuitant doesn't result in a death benefit. Rather, the owner names a new annuitant and the policy continues. The death of the owner requires the annuity to be paid out to the beneficiary within five years. The annuitant doesn't play an active role in an owner-driven annuity, other than to provide the measuring life on which annuity payments are based. An annuitant-driven annuity pays out a death benefit when the annuitant dies, but if the annuitant isn't the owner, the policy must be distributed within five years of the owner’s death. Either type of annuity can acquire a new owner.
Changing the Owner
The owner of a nonqualified annuity can sell the policy to a new owner and treat the sale proceeds as ordinary income. The current owner can give the annuity to a new owner and pay taxes on the excess of the surrender value above the cost basis. The surrender value is the amount you receive for cashing out an annuity after paying surrender fees. The cost basis is the amount the owner paid into the policy. The owner can also pledge a nonqualified annuity as collateral for a loan. If the owner fails to repay the loan, the creditor can take ownership of the annuity and either sell it or keep it.
Death of the Owner
When the owner of an annuity dies, the cash value or death benefit is paid to the beneficiary. However, if the beneficiary is the owner’s surviving spouse, the spouse can become the new owner and continue the annuity policy. For nonspouse beneficiaries, the five-year payout rule applies. If the owner dies before the annuity begins paying out, the policy distributes its cash to the beneficiary. Otherwise, the policy distributes the death benefit within five years. The death benefit might be larger than the cash value, depending on the policy’s design.
One reason why the non-annuitant owner of an annuitant-driven annuity might choose to sell the policy before the annuitant dies is to avoid gift taxes. This becomes a consideration when the beneficiary is neither the owner nor the annuitant. In this case, the death benefit is an “imputed gift” from the owner to the beneficiary, although spouse beneficiaries are exempt. If the death benefit exceeds $14,000, the excess reduces the owner’s lifetime gift tax exclusion. As of 2013, the first $5.25 million of gifts are exempt from gift tax. If the annuity is large, the owner might pay less income tax on the annuity sale proceeds than the amount she would pay because of the gift tax liability.
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