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Managing Generational Wealth Transfer with Trusts and Annuities

Leaving a Tax-Deferred Legacy: Managing Generational Wealth Transfer with Trusts and Annuities

The Important Role of Trusts

Irrevocable trusts are created for many reasons — from creditor protection, charitable objectives, and special needs protections to wealth management and estate and gift tax planning. Management of these trusts can be challenging. One must navigate a number of challenges including, but limited to: potentially high tax brackets, inflation, market volatility, and interest rate risks. Trustees are increasingly turning to annuities to help address these financial challenges. Trust-owned annuities can be a powerful tool to drive growth, preserve capital, and control taxes.

Establishing a Trust

Clients should work with an estate planning attorney and tax professional licensed in their state to establish their trust. They will determine all the relevant parties to the trust, including:

Grantor/Trustor/Settlor: the party that creates a trust, usually the donor¹

Trustee: a third party who is authorized to execute and manage trust assets²

Beneficiaries: the party for whose benefit the trustee holds the title to the trust property³

A trust is generally established to benefit the income beneficiaries and the remainder beneficiaries. The income beneficiaries may receive income from the trust while it is in force and the remainder beneficiary may receive the corpus of the trust at some point in the future.

Meet the Client

Now we meet our hypothetical family, The Freemans. John and Uma Freeman, a vibrant couple with a blended family that are facing a common challenge: securing their family’s future. John has two children from a previous marriage, John Jr. and Christine. John and Uma also have one child together, Dia.

The Freemans decide to establish a trust for the purpose of managing their estate plan. John wants to ensure that Uma and his children are taken care of in the future and that everyone receives their inheritance how and when it is intended.

A few years after establishing the trust, John passes away and Uma and her trustee meet with her financial professional to make decisions about the investments for the trust. They could choose to continue investing in a diversified portfolio of stocks, bonds, mutual funds, and cash, but they are concerned about the ongoing impact that taxes can have on their portfolio. In general, irrevocable nongrantor trusts reach the highest ordinary income tax bracket at considerably lower income levels than individuals.⁴

They decide that they like the idea of an annuity which can provide:

Tax-deferred growth⁵
Guaranteed lifetime income
A guaranteed death benefit
Principal protection

The Annuity Position

The trustee decides that putting some funds aside for the children’s retirement makes sense as part of the overall trust plan. The trustee will need to manage the assets during Uma’s lifetime, but the children will be able to take over the funds once Uma passes away. Uma and the children appreciate the tax-deferred nature of the trust-owned annuity, as it allows the annuity the potential to grow tax-deferred until it is time for the children to inherit a comfortable retirement fund.

The trustee works with Uma’s financial professional to purchase three annuities, one with each of John’s children named as the annuitant. Ideally, Uma has assets outside the annuity contracts that support her income needs, allowing the trust owned annuities to enjoy tax-deferred growth during Uma’s lifetime.

In Private Letter Ruling 2011240086 the IRS allowed the in-kind transfer of an annuity contract from a non-grantor trust to its beneficiaries without the realization of the taxable gain in the contract.

Upon Uma’s passing the trustee will request a change of ownership from the trust to the respective annuitants on each annuity, this is known as an in-kind transfer. The children will be established as owners of the tax-deferred contracts. No tax reporting is done as part of the change of ownership from the trust to the annuitants/named trust beneficiaries. Now as established owners, they will have the right to control the direction of their investment, name their own beneficiaries, elect income when appropriate — at their own marginal tax bracket, transfer or reallocate assets, or surrender.

Let's Compare

PASS-IN-KIND TITLING

Owner: Trust

Annuitant: John Jr./Christine/Dia

Beneficiary: Trust

Three $1M annuities are purchased by the trust for each of the children
Trust assets grow tax deferred for 10 years and are now worth $1.88M each
Uma passes away. Since she was not the annuitant, the death benefit is not triggered
The trustee requests the change of ownership to the children

The children each inherit $1.88M tax deferred

TRADITIONAL TRUST-OWNED ANNUITY

Owner: Trust

Annuitant: Uma

Beneficiary: Trust

$3M annuity is purchased by the trust
Trust assets grow tax deferred for 10 years and are now worth $5.6M
Uma passes away. Since she was the annuitant, the death benefit must be paid out as a lump sum or over 5 years
$2.6M of gains is taxable at the trust tax rate of 37% = $962,000 tax bill!

The children each inherit $1.546M

FOR ILLUSTRATIVE PURPOSES ONLY. The illustrated rates of return used are historical performance the ForeAccumulation fixed index annuity, allocated 100% to a S&P 500 index crediting strategy with a hypothetical 9.5% cap rate during the entire period from 01/2014-12/31/2023. Illustration does not reflect future performance of any product, strategy or index. Index strategy cap rates are guaranteed for the first Strategy Term but may change in subsequent strategy terms. Subsequent caps would differ in subsequent strategy terms and may be higher or lower than those illustrated. Past performance is no guarantee of future results. The illustration is designed to illustrate how the pass-in-kind strategy is designed to work, however does not constitute a recommendation of any product or service. Actual results will vary

What's the Opportunity?

As the financial professional, when may it make sense to discuss the pass-in-kind strategy? When well-funded, irrevocable non-grantor trusts have:

Clients and trustees who are tax sensitive
Long time horizons
Are designed to provide for future generations

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