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What Really Happens When an Annuitant or Policyowner Dies?
by Richard Duff, CLU

When you advise clients about annuities, it's normal to focus on the special advantages of the products, namely: tax deferral, policy guarantees, potential for growth (variable annuities), creditor protection, state insurance guaranty funds, liquidity, and withdrawal privileges. Unfortunately, the sales process doesn't always encourage healthy discussion regarding how to structure the annuity purchase. That's a shame.
This is an article on how to arrange policy ownership and annuitant and beneficiary designations for maximum tax and financial benefits down the road. You'll find this information helpful when counseling policyholders and prospects about how to make accumulation annuities part of their overall planning. You can also use the following strategies in seminars for existing annuitants and policyowners. If you do your job right, clients will recognize you as a creative and knowledgeable counselor who learns to gain maximum advantage from annuity products.

The Way Things Used To Be. Before January 18, 1985, some annuity investors named young children annuitants because they wanted perhaps 70 or 80 years of tax deferral. And that's a very long time.
Example: In 1980, Grandpa Bob purchases a $100,000 tax deferred annuity and names his grandson, Tommy, age five, annuitant. The policy states that a cash-out or annuitization is required only when the annuitant dies (or reaches, say, age 85 - the maturity date in the contract). If there are no withdrawals and these assumptions are correct, Tommy, at age 65, may have a policy worth about $12.8 million (seven doubles) if it averages merely eight percent interest over the years - all without income taxes to this point.

The Way Things Are Now. In the mid-eighties, Congress restructured "young annuitant" tax deferred planning, and some new paragraphs were written into Section 72 of the Internal Revenue Code. Effective January 19, 1985, all new accumulation annuity policies must (a) force out all funds within five years of a holder's death, or (b) begin a series of distributions (annuitization) within one year after he dies, if the holder is a "natural" person (Section 72(s)). As of November 1999, the IRS still hasn't issued regulations under this law. Without benefit of regulations, not all companies have made the same interpretation of the law. A policy's language usually looks like this: "If the owner (holder) dies before the annuity date (maturity date), the entire interest in the contract is distributed within five years of the date of death, unless the beneficiary takes distributions (annuitizes) commencing within one year of the date of death."
Some annuity policies alert beneficiaries to the important 60 day requirement. They specify that "any election to accept annuity payments in lieu of a lump sum must be made within 60 days of when the company receives proof of death." In other contracts, there is no mention of a 60 day limit - as if they don't want to give out the bad news. Nonetheless, at the death of a non-annuitant policyowner, a beneficiary of a post-January 18, 1985 policy is clearly subject to the 60 day rule.
You should know some other aspects of the 1984 law. For instance, consider the following planning pointers:
  1. If a married policyowner names a spouse beneficiary, the survivor can step into the shoes of the former holder. The effect: These surviving spouses can continue a policy and its tax deferral at least until they die. Literally, changes in owner and annuitant are made manually by amendment to the policy. If the survivor is already the annuitant, he now assumes ownership as well; a survivor who is only the beneficiary (and neither policyowner nor annuitant) becomes the successor owner and the primary annuitant. The policy carries its former policy number and any in-force surrender charges are still applicable.
  2. Some policies say that a surviving spouse automatically steps into the holder's shoes. Other contracts require an election; if so, I recommend making it within 60 days of filing the death claim. Otherwise, after 61 days, the survivor may be in constructive receipt of any taxable profit in the policy.
  3. Some annuity contracts permit spouses to be co-annuitants (and probably co-owners as well, for convenience). This designation may come in handy if there is a possibility of Medicaid planning in the future. Example: Harry and Mary, who are in their sixties, make themselves joint or co-annuitants. If either spouse is ever institutionalized, the other can annuitize the policy under Medicaid rules based on the community spouse's life expectancy. However, if either dies during the policy's accumulation phase, there is a tax issue if (a) the survivor owns the policy or (b) they own it jointly. In either case, the survivor already is the policyowner and cannot step into the holder's shoes. The result: The policy cannot be maintained as a tax deferred accumulation annuity.
  4. Let's say that Harry is a policyowner, and his wife, Mary, is beneficiary. If their son, Sam, is annuitant, it's possible for Mary to step into Harry's shoes someday and also name a new spouse beneficiary at her death. The result: If a new spouse steps into her shoes, he continues the tax deferral. Be aware, however, that some policies prohibit continuation of the contract if a surviving spouse remarries and then dies.
  5. In all cases, when a non-annuitant policyholder names a non-spouse beneficiary, this contract is subject to the 1985 force-out rules when the holder dies. In other words, the beneficiary must (a) annuitize the contract within one year of death or (b) cash-out within the next four years. If the policy isn't annuitized within 60 days after the day a lump sum is first payable (and the first annuity payment isn't received within one year of death), a beneficiary pays income taxes on any profit up to that point. Of course, there is a basis increase for the purpose of computing taxes on any distributions made thereafter.
  6. Sometimes, annuity sales commissions are reduced if the designated annuitant has reached say, age 75 or 80. Here, an agent may name a younger person annuitant, innocently seeking higher compensation from the insurance company. This decision can backfire on everyone. Let me explain. Example: Harry, age 81, purchases an annuity policy, and the agent advises that Harry name his son, Sam, as the annuitant. But then Sam dies before Harry. The result: The policy matures, and Harry can no longer maintain the policy on an accumulation basis. Since Harry unexpectedly survived his son, there is no more tax deferral. The bottom line: Always fully inform clients and prospects of their options, and confirm decisions in writing if there could be misunderstandings in the future.
  7. When a non-annuitant policyowner dies, it appears that some insurance companies don't issue 1099s after the 60 day period expires. But, of course, if the beneficiary flunks a 60 day test, he still must pay taxes on the policy's profit.
  8. All policyholders and their advisors should review in-force annuity contracts to interpret the distribution provisions for possible vagueness and limitations. For example, there may be automatic surrender charges at the death of a non-annuitant policyowner (but not at the annuitant's death). Or, there may be a waiver of surrender charges when an annuitant (but not a policyowner) enters a nursing home. Be aware of these restrictions and seek policies suited to your client's special facts and circumstances.
  9. There are some interesting issues concerning length of the annuitizing period:
    1. When a non-annuitant policyowner dies, an annuitizing beneficiary should not (under the 1984 law) select a payout period that exceeds his life expectancy. Otherwise, all profit is taxable within five years of the holder's death.
    2. When a non-owner annuitant dies, it appears the period certain can extend beyond a beneficiary's life expectancy.
    3. When owner and annuitant are identical, I suggest a conservative approach to simply limit the guaranteed payout period to a beneficiary's projected life expectancy.
  10. There are some pre January 19, 1985 contracts still in-force where a non-annuitant owner may be considerably older than the annuitant. The good news: These are "grandfathered" and may always be tax free until the annuitant dies. The bad news: If one of these policies is exchanged tax free under Section 1035 for another contract, the new policy must follow post January 18, 1985 rules. Therefore, if long-term tax deferal is important, it may not be sound planning to replace a grandfathered policy with even a more up-to-date contract.
  11. Let's suppose a holder or annuitant dies and you are consulting a beneficiary on what's ahead. There is significant profit in the contract; and you are advising on the possibility of annuitizing to spread out any taxable income. After determining this policy doesn't offer an attractive settlement annuity income option, you suggest exchanging it for another immediate annuity contract. There is a possible trap. The law refers to a 60 day option to receive an annuity "under the (first) contract!" Therefore, it seems that an exchange followed by annuitization (within the 60 days) is not permitted. If you professionally disagree, at the very least make the replacement policy effective (and annuitized) no later than 60 days after date of death.
Some additional pointers. When a beneficiary annuitizes a policy and takes a "life only" income, it's always possible a payout will be less than the investment in the contract. Here's some good news: If the annuity starting date is after July 1, 1986, there is a tax deduction (claimed on the beneficiary's last income tax return as a net operating loss from a trade or business) for any shortfall.
Example: Let's assume that a holder dies with an annuity worth $200,000. The investment in the contract (single premium) was $150,000, and the annual life only annuity payment is $18,000. The beneficiary dies in five years after receiving $90,000 (5 x $18,000). The result: There is a tax deduction for $60,000 (the $150,000 single premium less $90,000 in payments received).
A word of caution: It's easy to miss this tax deduction. Keep good records and help the beneficiary's estate claim any tax savings that might easily be overlooked. It's also possible that estate beneficiaries will forego an income tax deduction for death taxes paid when annuity values are included in a policyowner's estate tax base.
Example: Jean Hatfield dies owning an annuity worth $250,000. Her investment (premiums) in the contract was $100,000; the profit is $150,000. The full value of this policy is included in Jean's estate tax base, and it increases the federal portion of her estate tax by $80,000. Since 60% of the value at death is profit in the contract, her heirs can claim 60% of the estate tax as an income tax deduction when they cash out the policy.
Let's say they eventually surrender the policy for $300,000. The result: They'll deduct $48,000 (60% of $80,000 in estate taxes) against their taxable profit of $200,000 ($300,000 less $100,000).
A word of caution: Only the federal portion of estate taxes paid is eligible for a tax deduction. Also, beneficiaries of annuity policies are frequently unaware of this deduction. They may not even know a federal tax return Form 706 was filed or what the estate taxes actually were. Professional advisors can help by keeping good records and being proactive with families of their deceased clients.

Summary of Holder/Annuitant/Beneficiary Rules First Planning Issue. If an annuitant dies, a surviving spouse who already owns the policy cannot make a step into the shoes election. There is only a 60 day option to annuitize the contract and spread out any taxable profit. {Certain factors may allow continuation...Annuity Advisors}

Second Planning Issue. Where there is no surviving spouse, a beneficiary subject to the one-fifth year options still has merely 60 days to annuitize (and spread out the taxable profit) once a lump sum becomes payable. Of course, once an election is made, the first payment must be received within one year of the holder's death.

Third Planning Issue. A beneficiary subject to the one-fifth year requirement must select a payout period that doesn't exceed his life expectancy. Otherwise all policy profit remaining in the sixth year after the holders death is presumably taxable at once.

This is an abridged version of Dick duff's essay, "A Taxing Situation: What Really Happens When An Annuitant or Policyowner Dies." He has also published four new annuity reports: "How to Use Annuities in Medicaid Planning," "How Annuities Are Protected from Lawsuits and Creditors in the 50 States," "Why Variable Annuities Are a Good Buy," and "Annuities & Insurance Values - Insurance Guaranty Fund Limits." They can be ordered by calling Duff at 303-756-3599 (fax: 303-691-0474, email RWDuffCLU@aol.com).



Last Updated: 12/15/2002 10:44:00 AM