Mistake: Assuming all annuities are the same.
Annuities issued by different insurance companies and all operate differently. Always read the contract or prospectus, and if you don’t understand how the contract works, don’t buy it.
Mistake: No beneficiary or naming the estate as beneficiary.
When no individual is named as beneficiary or the estate is the named beneficiary, the annuity proceeds go to the owner’s estate. This would subject the annuity to probate and distribute according to your will or under state law. An important reason people purchase annuities is to avoid the probate process, so a beneficiary designation is intended to bypass probate. However, if no beneficiary exists, the proceeds go to the estate and distributed accordingly.
Mistake: No contingent beneficiary.
Naming a contingent beneficiary is crucial if the primary beneficiary predeceases the owner/annuitant. If no contingent beneficiary is named, the annuity will be paid to the estate, subject to the probate process. Naming a trust as contingent beneficiary helps when other issues that need to be taken into consideration arise.
Mistake: Not knowing if the contract is either owner or annuitant driven.
Non-qualified annuities can be either owner or annuitant driven, meaning the death of a particular individual can trigger certain events. If it is an owner driven contract, the death of the owner terminates the annuity and the proceeds are paid to the beneficiary. Likewise, the death of the annuitant will do the same. Keep in mind that misunderstanding the contract may result in a payout subject to surrender charges.
Mistake: Not naming both co-owners and co-annuitants
Similar to the previous mistake, not naming a co-owner or co-annuitant can inadvertently disinherit a spouse.
Mistake: Naming three parties to an annuitant driven contract
The potential for making an unintentional gift at the death of an annuitant triggers a payout to the beneficiary if owned by someone other than the annuitant. This results in a gift from the owner to the beneficiary and possibly exposes the owner to gift tax and in addition to the beneficiary paying income tax on interest earned. It is the worst possible scenario and a trust should be considered.
Mistake: Taxes due to changing ownership or assigning an annuity
If an annuity changes ownership or is assigned as collateral, all interest earned is subject to income tax at the time of the change. Some insurance companies may not generate a Form 1099 since no money was moved from the contract. But, you’re still responsible for paying the taxes due as well as penalties. Also, if the change of ownership results in a taxable gift of an amount over the annual exclusion, a gift tax form must be filed unless it’s between spouses.
Mistake: Purchasing more than one annuity from the same insurance company in the same year
Multiple annuities purchased in a calendar year from the same insurance company will be aggregated and treated as one for income tax purposes. This means that access to non-taxable basis will be delayed until the gains of both contracts have been distributed and taxed. For an easy remedy, either don’t buy in the same year, or don’t buy from the same company.
Mistake: Taking a withdrawal after making a partial 1035 exchange.
With a partial 1035 exchange, the basis and interest gains are prorated between the contracts. If you want to access your basis, this can be advantageous but if any withdrawals are made within 180 days of that partial exchange, the contract is aggregated for taxes.
Mistake: Not knowing about the non-natural person rule.
If a non-natural entity is named as the owner–such as a corporation, LLC, S Corporation, partnership, LLP, or UTMA/UGMA–the annuity is not eligible for tax deferral. The only exception are non-profit entities, as they do not pay income taxes.
Mistake: Not using an irrevocable trust due to the non-natural person rule.
The non-natural person rule does not apply to an irrevocable trust if named as owner. It’s eligible for tax deferral when acting as an agent for a natural person and several private letter rulings have confirmed this requirement as trust beneficiaries are individuals. However, there’s no life expectancy payout if the trust is the beneficiary of the annuity since no provision in the IRS code will allow it. When an irrevocable trust owns the annuity, all distributions must be paid out within 5 years from the death of the annuitant.
Mistake: Assuming the State Guaranty Association covers a fraternal organization
All insurance companies (with limited exceptions) licensed to sell annuities in a particular state are required to be part of the state’s Guaranty Association. If your insurance company becomes insolvent, the maximum amount of protection depends on the state. Annuities issued by fraternal organizations are not protected if that insurance company fails.
Mistake: Using a bonus for surrender charges.
If your annuity is no longer a fit, you can exchange it for another one but the existing contract might have surrender charges. If a financial advisor or insurance agent is using a bonus as a way to alleviate a surrender charge, be careful at what will be purposed. Often, annuities with bonuses have stipulations or weaker crediting options to make up for it. Also, the bonus might be vested, meaning the insurance company can recoup it if surrendered before the end of the term. With upfront bonuses, the annuity contract is usually much longer as a tradeoff.