Role of Annuities in Estate Planning

Despite the debates about estate taxes, many people continue to prioritize leaving an inheritance for their children through estate planning. 

About two-thirds (67%) of those who expect to leave an inheritance for their children say it is either their most important priority or a very important one, according to a survey by Northwestern Mutual, a financial services company.

While only 26% of those surveyed expect to leave an inheritance, 32% of millennials and 38% of Gen Z-ers expect an inheritance from their parents.

“In the coming years, we will see a staggering $90 trillion generational transfer of wealth, but who will see it depends a great deal on people’s financial planning,” according to Kamilah Williams-Kemp, the Chief Product Officer at Northwestern Mutual. 

“Long-term financial planning includes many goals and milestones, but the one that could have the most meaningful and lasting impact on families over generations is leaving a legacy through estate planning.” 

In this article, we will consider the role that annuities can play in estate planning, focusing on use cases, benefits and potential drawbacks. By the end of the article, you should have the information to decide if an annuity should be a part of your estate planning strategies and what role it should play (if any). 

Annuity Usage in Estate Planning

You must consider why you might want to transfer wealth to your heirs by creating annuities in their name (naming them as the annuitants). In the same boat, you should also consider how you can use existing annuities (where you are the annuity owner and annuitant) as part of your estate planning.  

Creating New Annuity Contracts for Your Heirs

While the annuitant and annuity owner are often confused, they are two different terms that may or may not overlap. 

The annuity owner is the person who creates the annuity contract, agrees to the terms, pays the premium, signs the contract and designates beneficiaries. On the other hand, the annuitant is the person who receives the annuity payments and on whose life expectancy the annuity owner and the insurer negotiate the contract. The annuity owner can also be the annuitant, and this is what applies in most cases. That is, the person who pays the premium and signs the contract is the same person who receives the benefits. 

However, there are cases where the annuity owner chooses someone else – a spouse, child or other relative – as the annuitant. In this case, the annuitant (who is not the owner) cannot designate a beneficiary, change the contract or contribute extra money to the annuity. 

For estate planning purposes, you can create an annuity with one or more of your heirs as the annuitant. 

Below are the main reasons for choosing this option:

Avoiding lump-sum payout

Your love for the beneficiaries of your estate does not mean you can trust their capacity to manage a windfall. A 1994 academic article in the Organizational Behavior and Human Decision Processes Journal concluded that windfall gains are more readily spent than any other asset type. 

Given this temptation, it might make sense to leave an inheritance in the form of regular payouts rather than a lump sum, at least for some beneficiaries. Such guaranteed and regular payouts can provide them with financial security by adding to their monthly income (for example). 

Managing risk

Suppose one of your beneficiaries is a stock trading enthusiast whose risk tolerance exceeds their risk capacity (takes more risk than they should). Here, you are concerned about them taking too much risk and losing the money rather than splurging it on luxuries. 

Annuities can also help here. A fixed annuity can guarantee a particular rate of return irrespective of market performance. Even fixed and indexed annuities tend to be less risky than other investment strategies.

Tax-deferred growth

Funds in an annuity grow tax-free. The annuitant will only pay taxes when they are withdrawing from the account. This can be beneficial for those who expect a lower income tax rate in the future. If one of your heirs is in this position, an annuity can be appropriate.

Using Your Current Annuity Contracts for Estate Planning

In addition to creating new contracts, you can also use existing contracts (where you are the annuity owner and annuitant) for wealth transfer to your heirs. 

There are five options to consider:

Surrender the annuity for a lump sum

If the contract has already reached the end of the surrender period, you can choose to cash out on the annuity and include the funds as part of your estate.

Transfer ownership to a trust

You can create a trust in the name of your heirs and transfer the ownership of the annuity to it. This transfer removes the annuity from your estate. The trust will become the recipient of the payouts and at your death, the death benefits will be transferred to the trust.

While the first two options apply in the accumulation phase, the next three apply during the payout phase.

Annual gifts to heirs

There is an $18,000 annual gift tax exemption for the 2024 tax year, according to the Internal Revenue Service (IRS). If you use your annuity distributions to make a gift of not more than $18,000 to your heirs, they won’t pay tax on it. While the distributions are taxable, “they won’t become part of your taxable estate and the gifts won’t eat into your lifetime estate tax exemption.”

Purchase life insurance

If you qualify, consider using your annuity distributions to pay premiums for a permanent life insurance policy. This will increase the amount your heirs will inherit. While the distributions are taxable, your heirs won’t pay tax from the proceeds of the life insurance policy. 

Charitable donations

Donating your annuity distributions will exclude them from your estate and it can also reduce your taxable income in the year of donation provided you itemize deductions.

Comparing Annuities With Other Tools

Annuities offer unique benefits when compared to other financial tools like trusts, life insurance and retirement accounts, each of which serves different purposes in estate planning.

Annuities vs. Trusts

A trust is another financial instrument that you can use if you are not very confident about your heirs’ ability to manage a windfall inheritance. 

It gives someone else (a trustee) control over how money is paid out to your heirs in tandem with the way you have specified in the trust. Some trusts will include conditions that an heir should not receive money before a certain age or if they are engaged in certain activities (drug abuse, for example).  

However, trustees also have discretionary power to pay money out in cases of emergencies. 

The trustee can be a mature and trusted family member or an organization (corporate trustee) with the requisite experience and skills. While the latter can be expensive, the former can lead to bad blood in the family. 

Though annuities also prevent a windfall to heirs, they are different from trusts in many ways. 

First, the heir receives guaranteed and periodic payments that are unrelated to good behavior and do not depend on the discretion of another person or entity. Second, corporate trustees are often more expensive than annuities. Third, while heirs can convince or blackmail trustees (especially non-corporate ones) to use their discretionary powers to their favor, they cannot modify the terms of an annuity contract.

Annuities vs. Life Insurance

Life insurance provides death benefits to the heirs of the insured after the insured passes away. Death benefits are lump-sum payments, and they are often received income tax-free by the heirs. 

On the other hand, annuities provide guaranteed and regular payments over a defined period (or a lifetime). Also, annuity distributions are taxed at the ordinary income tax rate. 

Annuities vs. Retirement Accounts

When the owner of a retirement account dies, the pending benefits are transferred to the designated beneficiary. This can be done as a lump-sum payment, an annuity or a rollover into another retirement plan.

Whether such transfer of benefits will be taxable or not depends on the type of retirement account – employer-sponsored plans (distributions are taxed), traditional IRA (distributions are taxed) and Roth IRA (distributions are not taxed).

If the funds in a retirement account are distributed to beneficiaries as annuities, then there is no practical difference between retirement accounts and annuities except the retirement account is a Roth IRA, in which case your heirs will receive tax-free distributions.  

Advantages and Disadvantages of Annuities in Estate Planning

Why should you consider including annuities in your estate planning? Let’s consider five key reasons: 

Advantages

• Ensuring guaranteed and regular payouts: We have seen that an annuity is a better option in cases where heirs will most likely mismanage windfall inheritance. They can provide financial security through regular and guaranteed payouts and reduce the temptation to splurge that comes with windfalls. 
• Minimizing risk: Annuities can also help to minimize risk and provide guaranteed income streams that are not subject to the volatility of financial markets. 
• It can be more cost-effective than other options: Trusts can be very expensive to set up and manage. Annuities can provide the same benefits at a lower cost.  
• Probate avoidance: Using annuities as part of your estate planning ensures that your estate will be distributed as you desire rather than left to a probate court. 
• Tax-efficient wealth transfer: There are four tax-efficient ways to transfer wealth through annuities. First, you can convert a Roth IRA to a Roth IRA annuity, allowing funds to grow and withdrawals to be tax-free. Second, annuity payments can be used to purchase a permanent life insurance policy for beneficiaries, with the proceeds being tax-free for your heirs. Third, you can donate to charity through a charitable gift annuity, providing tax write-offs. Lastly, you can reduce your taxable estate by making charitable donations or gifting annuity distributions to heirs or by transferring ownership to a trust.

Disadvantages

• Commissions and fees: Administrative fees, commissions, surrender charges, rate spreads and riders can make annuities very expensive. 
• Lower returns: The guarantee and downside protection that annuities provide come at a cost – lower returns than the market. If your heirs have high risk tolerance and capacity, the opportunity cost of an annuity may become too high. Furthermore, lower returns carry inflation risk – the risk that your returns will be lower than the prevailing inflation rate. 
• High complexity: Annuity contracts can be complex, and the term and underlying structure can have  a significant impact on the performance.
• Illiquidity: Annuities are meant to be long-term investments which is reflected in the surrender period that comes with them. Accessing your funds during this period comes at a cost – the surrender charge. 

Factors To Consider Before Choosing an Annuity

If you believe that annuities are a good option for your estate planning strategies, it’s important to understand how to choose the right annuity contract. Several factors should be considered to ensure you select the best option for your heirs.

Be sure to consider the contract type. There are at least five types of annuity contracts, each offering different rates of return, downside protection and payout schedules. Choose the one that aligns with your goals for your heirs, ensuring that the payout structure fits your vision for their future.

Next, be aware of contract fees. Annuities come with various fees, which can add up significantly over time. Before committing, make sure to inquire about all the associated fees. Additionally, it’s a good idea to shop around for insurers that provide the best value for your money, ensuring that fees are reasonable for the benefits offered.

The age, health and life expectancy of the annuitant—typically your heirs—also play a key role in determining the payout ratio. Ensure that you’re selecting an annuity that provides the best deal based on these factors, as they will influence the amount of money your heirs can expect to receive.

Another factor to consider is the availability and cost of death benefits. Many annuities offer death benefits as an additional rider, which can add extra costs to the contract. Look for annuities that provide death benefits without an added charge or at a lower cost as this can be a valuable feature for your estate planning.

Finally, ensure the financial stability of the insurer. Annuities are not FDIC-insured, so it’s crucial to evaluate the financial health of the insurance company providing the annuity. Check the company’s ratings from agencies like Fitch, Moody’s and Standard & Poor’s, and review their historical performance to ensure they can reliably meet their obligations.

Incorporating annuities into your estate planning can help ensure your wealth is distributed according to your wishes, bypassing the probate process and giving you control over how your estate is handled after your passing.

Annuities are financial products that are often included in the estate planning process. You can create annuities in the name of your heirs or distribute funds in your annuities to benefit them.

There are many pros and cons to using annuities in estate planning. Before deciding on if and how to use them, ensure you speak to your financial advisor.