Life insurance and annuities are examples of assets that may fall outside of the estate and trust administration. This is due to the fact that these assets are generally distributed pursuant to a designation of beneficiary document.

Life insurance is typically owned by the decedent, but may be owned by the decedent’s spouse, children, or by an irrevocable life insurance trust (ILIT). First, I’ll review what happens when a family member owns the life insurance; after that, I’ll review the ILIT.

When a family member owns and is designated as the beneficiary of a life insurance policy insuring the life of the decedent, then a claim form must be filed with the company. The company will typically ask you to submit the original life insurance policy itself, along with the claim form and a long form death certificate (showing cause of death).  Once processed, the company will then issue checks to the beneficiaries in the percentages indicated on the designation of beneficiary document.

When the decedent’s estate is taxable, it will be important to request an IRS Form 712 from the life insurance company when making the claim on the policy. This is an important document that you will want to give to your attorney or CPA who will be preparing the Federal Estate Tax Return Form 706.

While life insurance is usually income tax free, it is not always estate tax free. That is why the Form 712 is necessary. Failure to file a Form 712 when one is necessary greatly increases the likelihood of an IRS audit on the Federal Estate Tax Return and the assessment of additional taxes, interest, and penalties.

Life insurance can be more difficult if the decedent owned the policy, but was not the insured. An example of this is when Mother owns the policy on Father’s life, but Mother dies first. The policy is not ripe to make a claim since the insured (Father) is still alive. But now Father can’t transfer the policy or change the beneficiary designations, borrow against the policy, or cash it out, as Mother, who is now deceased, owns the policy.

In this situation, the life insurance policy will be a probate asset, subject to the terms of Mother’s will. If Mother’s will gives everything to Father, then when the probate court process is complete, Father will now own the policy on his life and can do with it as he pleases. If instead Mother’s will is a pour-over will (typical with those who also have revocable living trusts), then the policy will end up with the trustee of the trust for distribution in accordance with the trust terms.

Irrevocable Life Insurance Trusts (ILITs) that own life insurance policies are also quite common. Here, the ILIT owns the life insurance policy and is almost always also the beneficiary of the policy. Even though the policy is not owned by the decedent, when the decedent has a taxable estate, it will be important for the ILIT trustee to obtain a Form 712 when making a claim on the policy as described above.

The issues surrounding ILITs could fill up another book (and I do plan to write such a book in the future), so I won’t go into all of the details that your attorney should lead you through when engaged to assist the ILIT trustee with the claim, accountings, taxes, and distributions. It is important to note, however, that the beneficiaries of the ILIT may or may not be the same as the beneficiaries of the will or the revocable trust. Similarly, the trustee may or may not be the same as the trustee named in the revocable trust.

Nonetheless, it’s important for the trustee of the ILIT to coordinate efforts with the attorney and CPA for the estate to make sure that all necessary reporting requirements are satisfied and that the beneficiaries are properly notified of the insurance claim, income earned, taxes and expenses paid, and schedule of proposed distributions consented to before final distributions are completed.

Unlike life insurance that is generally income tax free, annuities are not and therefore pose several challenges when administering an estate or trust. Most annuity contracts feature tax-deferred growth of principal, meaning that when one invests in the contract, it grows tax deferred; when distributions are made, there is an element of return of principal (income tax free) and income/growth (subject to income taxation).

Legal, tax, and financial professionals refer to these types of assets as “Income with Respect to a Decedent (IRD)” assets. Annuities, Individual Retirement Accounts (IRAs), and 401(k) accounts are all IRD assets.  IRD assets do not enjoy a “step-up” in tax cost basis as do traditional investment accounts that contain stocks and mutual funds.

Unlike IRAs and 401(k)s that are all governed by standard laws regarding their distributions and income taxation, annuity contracts can all be very different. Some annuity contracts terminate at death with no benefits, while others may continue on for a surviving spouse and/or other beneficiaries. Some require a lump sum distribution of benefits at death, while others can continue on for a term of years or for the lifetime of the beneficiary. Still others contain tax-free life insurance as a death benefit.

Which options are available and what options are chosen may have a real economic effect on the annuity’s beneficiaries. While one option may look more appealing from a distribution standpoint, it may also have more significant adverse income tax consequences. While no one knows what the future brings, an assessment of the family’s needs and concerns should be carefully evaluated.

When an annuity names a testamentary trust as the beneficiary, the income tax effects should be closely evaluated. The trustee may be able to mitigate the tax consequences by making what are known as “conduit” distributions, meaning that whatever the annuity distributes to the trust, the trust distributes to the income beneficiary. Doing this, however, fails to preserve the principal or corpus of the annuity for the remainderman beneficiaries. The relative tax consequences and needs of the income and remainderman beneficiaries should be considered prior to making distribution decisions.

For all of these reasons, it’s a good idea to engage the services of your attorney, CPA, and financial advisor to determine the options associated with any given annuity and to advise as to which distribution election to choose and how to report the annuity on the decedent’s and estate/trust tax returns.

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