Annuities Can Offer Spendthrift Protection

People buy fixed annuities outside qualified retirement plans for a variety of reasons. They include:

Tax Deferral

Most buy annuities because they are guided by their advisers to do so in order to build up compound interest in their account and not pay current income tax on the growth. For them, this tax benefit is paramount even though they know the growth will be taxed as ordinary income to them later if and when the money is withdrawn from the account.

Lifetime Income

Others acquire annuities for the guarantee of lifetime income. When a life-annuity income is started, usually at retirement age, the insurer takes the age of the annuitant, the amount of money available for this payout and the prevailing interest rate at the time to calculate the amount of annual or more frequent payment to the annuitant. The insurer guarantees this payment until death. No tax penalty applies to such payout annuities.

Spendthrift Protection

A financially savvy parent or other concerned relative can use the guarantees and legal protections of annuities for yet another purpose. "Spendthrift" provisions in state law or case law are designed to protect the benefits in annuities and life-insurance settlement options from the claims of creditors of beneficiaries. These provisions vary from state to state.

Thus, a person ("Mary") can buy with a lump sum an annuity that begins its payout immediately (a single-premium immediate annuity or "SPIA") to the income recipient ("Edward").

If Mary retains the ownership of such an annuity policy, then the interest portion of each year's annuity payments will be taxed to her as ordinary income. The total value of each year's payments will be potentially considered a taxable gift, partly or fully eligible for the gifttax annual exclusion. And at Mary's death the present value of future payments under the contract will be includible in any estate-tax calculations for Mary's estate. And Mary's creditors, but not Edward's may be able to reach the contract's benefits.

When Mary dies, she has probably named Edward to succeed her as owner. Now, without careful planning Edward's present or future creditors, if any, will be able to reach the benefits. And Edward will be able to assign the benefits in exchange for cash or as collateral for a loan.

To avoid this possibility, Mary during her lifetime can build in spendthrift protection by making the policy non-transferable and non-assignable. This will serve to preserve the annuity benefit for Edward for the duration of the income period; even for Edward's lifetime.

In this case Mary makes an immediate, sizable, potentially taxable gift to Edward, who himself will then report as ordinary income for income-tax purposes the interest portion of each annuity payment received.