7 Annuity Mistakes Advisors And Clients Make

A while back I did a multi-part series on annuities. The complexity of annuities necessitated multiple articles just to cover a good portion of what you need to know. In the articles, I left out some of the more complex mistakes people make regarding them. This week let's cover some lesser seen but potentially problematic situations surrounding annuities.

First, annuity contracts can be either owner driven, or annuitant driven. This is not a commonly known distinction. The owner of the contract is the person who bought and controls it, pays the premiums, makes withdrawals, etc. whereas the annuitant is the person whose life the contract benefits are based on. In an annuitant driven annuity, the contract ceases upon the death of the annuitant. For owner driven contracts, it's the death of the owner that causes the annuity to terminate. The vast majority of annuity contracts are owner driven. Who cares about the difference? Well, it becomes important as we see when changes (and potentially mistakes) are made to the contracts.

Mistake #1: Changing the owner of a non-IRA annuity to anyone but your spouse. Let's say you were the owner of an annuity, and your sibling was the annuitant. If you wanted to transfer ownership to them, this would be considered a taxable event. Worse, it is taxable to you the owner. The same goes for later adding them as an owner to the contract. The only time it doesn't create a taxable event is when a spouse or revocable grantor trust is added.

Mistake #2: Using a non-IRA annuity as collateral for a loan. Often, loan companies want collateral for the loans they provide. Using a non-IRA for that collateral or assigning it to someone creates a taxable event. Worse, if you are younger than 59 ½ you are subject to the 10% penalty as well.

Mistake #3: Naming a minor as the beneficiary of an annuity. A minor cannot own legal property so leaving your annuity to a minor could cause guardianship issues (particularly if the parents later divorce). Courts can decide who the guardian of the property would be, and it might not be the person you would have chosen for yourself.

Mistake #4: Unless your attorney has specific reasons for wanting you to transfer an annuity to a revocable living trust, there is no need to do so. Annuities are already tax deferred and not subject to probate, and since they pass via a named beneficiary there really is no need to have one inside the revocable living trust.

Mistake #5: Ignoring partial distribution rules. If you exchange a portion of an annuity for another annuity, you can not take a distribution from either annuity for 180 days. This applies only to partial distributions from an annuity. If you take a distribution within 180 days, the IRS will deem the distribution to be a part of the original exchange. The purpose of this rule is to avoid potential abuse. The IRS doesn't want you to try to split the gain from the cost basis of an annuity contract into a new contract and then try to take out funds from the contract with no gain. All cost basis would be pro-rated between the 2 contracts. The exception to this rule is if you annuitize the contract over a period of more than 10 years.

Mistake #6: Making a gift of an annuity to a charity. This gift is a taxable event and while the gift is tax deductible, since it is a gift of non-cash, the deduction is limited.

Mistake #7: Naming an estate the beneficiary of an annuity. Naming your estate as the beneficiary of a non-IRA annuity makes a normally non-probate asset subject to probate. This will cost both time and money. This also makes it subject to creditors.

Annuities for the right client can be great but making mistakes once you own it can cost you or your heirs a lot of unnecessary expenses and headaches. Make sure you seek competent legal and financial council before making any changes to them.