The opportunity to obtain tax-deferred growth in a non-qualified deferred annuity is a key feature of the contracts, particularly for those who face high tax brackets and have already maxed out other available tax shelters. An added benefit is that non-qualified annuities aren’t even subject to RMD obligations during the lifetime of the annuity owner.
However, a significant complication of annuities is that upon the death of an annuity owner, the beneficiary must begin post-death Required Minimum Distributions from the contract. And notably, the post-death RMD obligation occurs at the death of the first owner with a jointly owned contract, which means that a surviving joint owner can even be forced to liquidate their own asset and trigger a taxable event!
Fortunately, the tax law does allow for “spousal continuation” of an annuity payable to a surviving spouse. But that rule triggers based on whether the spouse is named as the beneficiary, not the joint owner. In fact, once a surviving spouse is properly named as a beneficiary, there’s often no reason at all for the annuity to be jointly owned anymore!
And between non-spouses, the situation can be even more problematic, as the death of one annuity owner can force the surviving owner to begin taking “stretch annuity” payments over his/her life expectancy, even if it was the survivor’s money in the first place and he/she doesn’t want it!
Which means in the end, most situations where an annuity is jointly owned, it probably shouldn’t be, as most of the benefits of joint ownership can be accomplished by other means when using an annuity anyway (unless specifically pursuing contractual living or death benefit guarantees that are designed to apply for both spouses jointly). And in situations where it’s not actually necessary to jointly own the contract anyway, by not owning the contract jointly, the risk of unintentionally forcing the contract to be liquidated at an undesirable time is greatly reduced!
The Taxation Of (Jointly) Owned Deferred Annuities Under IRC Section 72
To encourage their use as a retirement accumulation vehicle, Congress enacted IRC Section 72, which provides favorable tax treatment for a so-called “non-qualified” annuity held outside of a retirement account. (By contrast, an annuity inside a tax-qualified retirement account is a “qualified” annuity that already gets beneficial tax treatment by virtue of the retirement account wrapper.)
Specifically, when it comes to non-qualified annuities, Section 72(u) provides that the annual gains of an annuity (the “income of the contract”) are not taxable each year, as long as the annuity is held by one or more natural persons (living, breathing human beings, or a trust/entity serving as an agent for a natural person). Instead, the gains are only taxable when actually taken out of the contract, either by annuitizing it, or by taking a withdrawal from the annuity while it is still in deferred status (in which case the distributions are treated as “gains first” under Section 72(e)).
This treatment where gains in an annuity are tax-deferred as long as the funds are left in the account, and only taxable upon withdrawal, is similar to other qualified retirement accounts like IRAs and 401(k) plans. However, a ‘unique’ benefit of the non-qualified annuity is that, unlike other retirement accounts, there are no Required Minimum Distribution (RMD) obligations imposed upon the account to force money out in a taxable distribution. Instead, as long as the non-qualified annuity owner remains alive, the funds can remain in the annuity, and tax deferral can be maintained as well.
Post-Death RMD Obligations After The Death Of Any Annuity Owner
The opportunity to keep funds inside a deferred annuity, continuing to enjoy tax-deferred growth, and without any RMD obligations, is a highly appealing feature of using such contracts. For those facing top tax brackets, when purchased for a low enough cost the extended tax-deferral time horizon can make it worthwhile to buy a non-qualified annuity solely as a tax deferral vehicle alone. Especially for high-return tax-inefficient investments, where an investment-only annuity can operate as an asset location tax-sheltering vehicle.
However, a significant caveat of the “no RMDs” tax deferral treatment is that it only applies as long as the annuity owner is alive, because IRC Section 72(s) stipulates that upon the death of any owner the annuity must begin to make post-death distributions to the beneficiary.
The key phrase, though, is that Section 72(s) requires that an annuity must begin a beneficiary payout upon the death of any owner. Which means in a scenario with joint ownership of an annuity, the contract must begin to pay out not upon the death of the last surviving owner, but immediately upon the death of the first owner to pass away!
Spousal Continuation Of A Deferred Annuity
In cases where a surviving spouse is the beneficiary of a non-qualified annuity, Section 72(s)(3) provides a special “spousal continuation” rule allowing the surviving spouse to continue the contract in his/her own name, as though he/she was the original owner for tax purposes. The functional equivalent of the “spousal IRA rollover” rule for beneficiaries of retirement accounts, annuity spousal continuation allows the surviving spouse to continue to enjoy the benefits of tax deferral, and control over when to take distributions from the annuity.
Notably, though, a key distinction of the spousal continuation provision for a non-qualified annuity is that the driving factor to allow continued tax deferral is not the joint ownership of the annuity, but the spousal beneficiary of the contract. In fact, whether the spouse is the joint co-owner of the annuity or not is completely irrelevant; even if just owned individually in the name of one spouse, as long as the other spouse is named beneficiary, then spousal continuation is an option. Conversely, though, if the contract is jointly owned between spouses, but the surviving spouse is not the beneficiary, then whoever is named as beneficiary will be required to begin post-death required minimum distributions from the annuity contract and spousal continuation is lost!
Fortunately, some annuity contracts indirectly prevent this especially unfavorable outcome, by contractually stipulating that any time there is a surviving joint owner, the joint owner is presumed to be the primary beneficiary, overriding any other beneficiary designation form. This would allow the surviving spouse to continue the contract after all… but only if the particularly contract in question actually includes such an override provision!
Post-Death Annuity Distributions To Non-Spouse Beneficiaries: Life Expectancy Stretch Annuity And The 5 Year Rule
In any case where an annuity owner passes away and the designated beneficiary of the annuity contract is not the spouse to which the owner was legally married, the annuity must begin post-death RMDs based on the life expectancy of the beneficiary. If the beneficiary is not a living, breathing human being that has a life expectancy – e.g., if the annuity is left payable to a trust – then the annuity is subject to the even-less-favorable 5-year rule, which means that the entire contract must be liquidated to the beneficiary by the 5th anniversary of the original owner’s date of death. The non-living beneficiary can take distributions all at once, or spread them out across several years, but either way the entire account balance must be distributed by the 5th anniversary of the decedent’s date of death.
In the context of a jointly owned annuity between non-spouses, this treatment is significant, as it means even though the joint owner is still alive, since there is no spousal continuation available, the surviving joint owner will be forced to begin “stretch annuity” life expectancy distributions after the death of the first owner. In other words, the surviving joint owner will be required to take post-death RMDs from his/her own annuity!
The Ineffectiveness And Problems With Annuity Joint Ownership
One of the most common reasons for property owners to title the property jointly – particularly in the case of spouses – is to ensure that upon the death of one owner, the property will go to the surviving joint owner, who can continue to maintain it as his/her own.
However, in the case of an annuity, joint ownership does not necessarily lead to this outcome. Instead, upon the death of the first owner, the beneficiary must begin to liquidate the annuity by taking post-death required minimum distributions over life expectancy (or the 5-year rule for a non-natural-person beneficiary). Only a spouse is permitted to continue the annuity after the death of the original owner, and even in the case of spousal continuation, the favorable treatment is driven by the beneficiary designation of the annuity, not its joint ownership.
And joint ownership of an annuity can be especially problematic in situations where the named beneficiary is not the surviving joint owner (even if the joint owner is a surviving spouse). In that case, not only will the death of the first owner mean the beneficiary is required to begin post-death required minimum distributions from the contract (even though the joint owner is still alive), but the joint owner can be outright disinherited! Even worse, if the surviving joint owner had partially contributed funds to purchase the annuity, then that joint owner will be required to file a gift tax return to report his/her share of the annuity that was just “gifted” to the beneficiary!
Example 1. Arnold and Betty are married and jointly own a non-qualified deferred annuity, naming their son Jerry as the beneficiary. In this situation, if Arnold were to pass away, the annuity contract would be required to pay out (even though Betty is still alive), because he is the first owner to die. And since the beneficiary is Jerry, and he is Arnold’s son (not Arnold’s spouse), there is no opportunity for spousal continuation; instead, at best Jerry can just take stretch annuity payments over his life expectancy. In addition, even though Betty is still alive and was a joint owner of the annuity, the entire contract is transferred to Jerry upon Arnold’s death, and Betty will be required to file a Form 709 gift tax return to report her lifetime gift of her share of the annuity to Jerry!
Notably, in the example above, the annuity was jointly owned between spouses, but ultimately did not receive spousal continuation treatment, because the spouse was not actually the named beneficiary. In addition, not only did the couple lose spousal continuation treatment, but in the process, the wife was both disinherited and forced to report a gift of her own share of the annuity money to the beneficiary!
As noted earlier, such an outcome could be prevented if the contract includes provisions that override the beneficiary designation and automatically name a surviving joint owner as beneficiary (which would avoid leaving Betty disinherited and being forced to file a gift tax return). But ultimately this will depend upon the terms of the contract, and ironically would only serve to repair a situation where the surviving joint owner probably should have just been named as the primary beneficiary on the beneficiary designation form in the first place!
And notably, in situations where the joint ownership is between non-spouses, even having the beneficiary designation payable to the surviving joint owner still doesn’t prevent a required payout from the annuity!
Example 2. Susan is a single elderly widow who owns a non-qualified deferred annuity, and she added her daughter Jessica as a joint owner to the contract to make it easier for Jessica to make financial decisions and handle the annuity contract on her mother’s behalf. However, the family’s planning strategy is disrupted when Jessica, the daughter, unexpectedly passes away in a car accident. As a result of her death, there has been a death of “any owner” of the annuity, which means the contract must begin to pay out. Hopefully, Susan as the surviving joint owner will have been named as the beneficiary so she is not disinherited from her own annuity; nonetheless, even as the beneficiary, Susan will be required to begin taking life expectancy distributions from her own annuity, funded with her own contributions, triggered by the death of the first joint owner!
Superior Alternatives To Joint Ownership of Annuities
Given these problematic dynamics, the reality is that in most situations where a non-qualified deferred annuity is jointly owned, it really shouldn’t be.
In the case of a married couple, if the goal is to ensure that the annuity goes to the surviving spouse after the death of the first owner – and that it obtains favorable spousal continuation treatment – the key is to name the surviving spouse as beneficiary, not joint owner. Thus, if both spouses want to contribute to a joint annuity, they may as well own two annuities, one in the name of each spouse, with the other as primary beneficiary.
In situations where it’s necessary for joint ownership of a single contract – for instance, in scenarios where the couple is purchasing an annuity with a guaranteed withdrawal rider that is applicable as long as either/both spouses are alive, to maximize an enhanced death benefit that may apply at each death (allowing step death benefit step-ups for each spousal joint owner), or because the couple wants to ensure that joint marital property remains titled jointly as marital property – it’s crucial to ensure that “surviving spouse” is named as the primary beneficiary, to at least ensure less favorable tax treatment doesn’t occur accidentally. Fortunately, though, since the Obergefell v Hodges Supreme Court decision last year, favorable spousal continuation treatment is available for same-sex married couples as well, which the IRS recognizes as long as the marriage was legal in the state in which it was celebrated (regardless of whether the couple currently lives in a state that recognizes the marriage).
With non-spouse joint owners, though, it’s even less clear when it would ever be appropriate to utilize a single annuity contract with joint ownership. In situations where the goal is to provide someone else – e.g., a family member – with legal rights and access to control the annuity, it is far more effective to obtain a proper Power of Attorney document, or use a revocable living trust as the annuity owner, because it avoids the risk of “accidentally” triggering an annuity payout if the “wrong” joint owner dies first. In situations where two people genuinely want to pool resources and jointly own a contract, it’s arguably still preferable to own two separate contracts and simply name the other person as beneficiary; otherwise, the surviving owner will inevitably end out being required to take distributions, including of his/her own principal and growth, when the other joint owner passes away and triggers the requirement.
It’s important to remember, though, that the Section rules pertaining to joint ownership of non-qualified annuities is only for non-qualified contracts that are held outside of an IRA or other retirement account. For annuities held inside of a retirement account, the rules pertaining to that type of retirement account control (regardless of the fact that an annuity happens to be inside). On the other hand, the reality is that retirement accounts already require that every account be owned individually and not jointly. The fact that non-qualified annuities happen to be more flexible and permit joint ownership, though, doesn’t mean it’s a good idea to actually do it, and risk introducing more complications and less favorable outcomes!
For those looking for additional objective information regarding the technical rules and taxation of annuities in general, check out my book “The Advisor’s Guide To Annuities” as well!
So what do you think? Have you ever had scenarios where clients wanted to jointly own an annuity? Did you leave the contract as jointly owned, or separate into two contracts? Please share your thoughts or questions in the comments below!