Prepare for the Potential Estate and Gift Tax Sunset

09/20/2024

Amy Justus, JD
Assistant Director – Advanced Solutions

As an Assistant Director for Advanced Solutions, Amy is a resource for various areas within the company, as well as financial professionals. She provides point-of-sale assistance on complex cases relating to tax, legal, and regulatory matters concerning annuities, IRAs, trusts, estate, business, executive benefit, and financial planning. As part of her work for Principal’s Personal Trust department, she also provides consultation and review of personal trusts.

Without congressional action, changes to U.S. tax law may be coming Jan. 1, 2026, that could be of interest to high-net-worth clients. The Tax Cuts and Jobs Act of 2017 (TCJA) is scheduled to sunset. TCJA increased the gift and estate tax exclusion amount and the Generation Skipping Transfer Tax (GSTT) exemption, effectively doubling the limits in effect prior to its passage.

Currently, the exclusion amount per person, indexed for inflation in 2024, is $13.61 million ($27.22 million for a married couple). Unless congress acts before Jan. 1, 2026, this exclusion amount will drop to $5 million per person, or roughly $7 million when indexed for inflation.

To take advantage of the current high exclusion amounts, high-net-worth individuals and their attorneys may look to implement estate planning strategies prior to the 2026 deadline. These strategies often involve the use of trusts to remove assets from the client’s taxable estate. As a financial professional it’s important to understand how different assets, like annuities, may be affected by trust-centered strategies.

Trusts are used often in estate planning. Putting an annuity in a trust can be a way to shift some of the tax burden out of your client’s estate if they are in good health and want to provide ongoing funding for beneficiaries. This strategy can allow the client to create funding while they are alive and get their legacy started early. But annuities also have different intricacies and tax implications that will affect what guidance you provide to a client.

Remember these four considerations when weighing potential benefits versus the tax consequences.

Consideration No. 1: Potential Loss of Tax Deferral

Tax deferral is considered a major benefit for nonqualified annuities. But this doesn’t apply if the annuity is owned by a non-natural person (e.g., trusts, corporations, partnerships, and LLCs). However, an exception exists for entities that are "agents for natural persons". This allows certain trusts to own annuities without being subject to income tax on the inside buildup of the annuity.

Although there are no cases or published rulings, several private letter rulings (PLR) have addressed the question of when a trust qualifies as an agent of a natural person. If a grantor trust is used to hold the annuity contract, and a natural person is treated as the owner, the trust is treated as holding the annuity contract for that natural person.

Non-grantor trusts are more difficult to determine. In PLRs for non-grantor trusts the current and potential beneficiaries must be analyzed and identified. If all beneficiaries are natural persons, the trust is considered to hold an annuity as an agent for one or more natural persons.

Consideration No. 2: Recognition of Deferred Gain on an Annuity Contract as the Result of a Transfer

According to IRC § 72(e)(4)(C), when an individual transfers a contract without full and adequate consideration, they are treated as receiving the excess of the contract's cash surrender value over the investment in the contract. Transfers as gifts to irrevocable trusts would therefore result in the owner recognizing all deferred gain. However, transfers to grantor trusts set up by the owner should not result in recognition, as grantor trusts are ignored for income tax purposes. It’s important to note that recognition of gain only applies to transfers from individuals to an irrevocable trust and not transfers from trusts to individuals.

Consideration No. 3: Withdrawals from Annuities Without Annuitizing the Contract Are Taxed as Ordinary Income Until All Growth Is Withdrawn

The exclusion ratio allows a portion of each annuity payment to be treated as a recovery of the owner's basis in the annuity, and a portion as ordinary income. But this only applies if the withdrawal is taken from an annuitized contract. Amounts withdrawn without annuitizing are taxed on a last-in, first-out basis. This creates a more significant issue for non-grantor trusts than for individuals because they are subject to a compressed tax rate bracket.

Consideration No. 4: Distribution Options after Death are Limited

If a trust is the beneficiary of a nonqualified annuity, the trust must take the annuity as a lump sum or receive the annuity balance within 5 years of the annuitant's death. The options available to individuals and spouses, even if the spouse is the sole beneficiary of the trust, are not available to a trust. Further, the 5-year distribution requirement deadline, unlike the 5-year deadline for IRAs and qualified plans, ends on the fifth anniversary of the triggering death and not on December 31st of the year that includes the fifth anniversary of the triggering death.

Your next steps

Use this quick reference guide to determine if a trust-owned owned annuity is right for your client. And visit principal.com if you are interested in learning how personal trust solutions can help you manage additional assets through the creation of a new trust, or transfer of an existing trust.

Principal Trust Company^® works with you, your clients, and their centers of influence to pinpoint opportunities where you can manage assets under a trust scenario, and your clients can benefit from one of the more favorable and flexible trust jurisdictions.

The subject matter in this communication is educational only and provided with the understanding that Principal^® is not rendering legal, accounting, investment or tax advice. You should consult with appropriate counsel, financial professionals, and other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

Custody and trust services are provided by Principal Bank®, Member FDIC, and/or Principal Trust Company^®. These services are provided under the trade name Principal® Custody Solutions. Principal Trust Company is a trade name of Delaware Charter Guarantee & Trust Company. Annuity products and services are offered through Principal Life Insurance Company®. Securities offered through Principal Securities, Inc., member SIPC, and/or independent broker/dealers. Referenced companies are members of the Principal Financial Group®, Des Moines, Iowa 50392, principal.com.

Principal^®, Principal Financial Group®, and Principal and the logomark design are registered trademarks of Principal Financial Services, Inc., a Principal Financial Group company, in the United States and are trademarks and service marks of Principal Financial Services, Inc., in various countries around the world.

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