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Using annuities for spendthrift protection in estate planning

by Joseph Arroyo | Contributor
June 3, 2020

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Leaving money to an heir who is irresponsible with money can undo the purposes of an estate plan and squander your financial legacy. Heirs who waste or spend an inheritance are known as spendthrifts. Protecting estates from spendthrifts has been the focus of centuries of planning and strategy. Today, two options are commonly used for spendthrift protection: trusts and annuities. We'll the review the advantages and disadvantages of each of these products.

What are the advantages of using a trust for spendthrift protection?

Using a trust to preserve wealth is often the go-to strategy for estate planning. Trusts created to minimize an heir's ability to overspend are often called spendthrift trusts. A trust is a legal entity that holds assets and requires the grantor — the person establishing the trust — to appoint a successor trustee. The trustee is responsible for managing and distributing the trust assets as spelled out in the trust documents.

There are several benefits to using a spendthrift trust:

  • Protects assets from creditors
  • Allows for precise customization
  • A specific individual (the trustee) is empowered to facilitate asset transfers from the trust

The bulk of the advantages come down to flexibility. With a trust you can customize the terms of payment to any degree you like. Having a self-appointed successor trustee allows them to exercise some discretion relating to payments. While still guided by the terms of the trust, the trustee can be enabled to make decisions about any unusual or unforeseen circumstances that may arise. Perhaps the beneficiary suffers a severe illness and needs money to cover medical bills. A trustee may have the power to accelerate payments in such emergency situations.

What are the disadvantages of using a trust for spendthrift protection?

The disadvantages of a formal trust come down to initial expense, ongoing administrative burdens and expenses and the potential for personal hard feelings and confrontation.

For starters, you'll spend money having the legal documents drafted. Beyond this initial cost, you'll have to have a tax return filed for the trust in any year during which it has income of more than $600. This will probably cost money, too, unless the trustee is capable of filing the tax return.

If the trust should retain earnings, like if it earns interest and dividends faster than it pays them out to the beneficiary, there could be taxes owed.

Another potential problem with using a trust is that the trustee must be identified in the trust documents. Your spendthrift heir will know who the trustee is. This could cause some discomfort, especially if you're using a family member or friend to act as the trustee. In this case, the beneficiary could confront the trustee about the restrictions placed on their income. Needless to say, this would be very uncomfortable for your trustee.

What are the benefits of using an annuity to preserve income for a spendthrift?

You can accomplish the same goal (preventing your hard-earned wealth from being wasted by a spendthrift heir) with an immediate annuity. Doing this can have several advantages over establishing a formal trust:

  • All administration is handled by the insurance company
  • No upfront fees for documents
  • Tax reporting needed only by annuity's beneficiary regarding interest included in an annuity distribution

Using this option, your successor trustee would be directed to purchase an immediate annuity as part of your estate plan. Your estate wouldn't pay any kind of setup or administrative fee. Your trustee would just fund the annuity with the amount of funds you want passed to your heir.

The insurance company handles all the accounting of interest earned and payments made. There are no tax forms to be filed by your successor trustee, and no potential to owe taxes for your trust. The insurance company handles all the accounting of interest earned and payments made. There are no tax forms to be filed and no potential to owe taxes.

You would specify your spendthrift heir as the beneficiary. Many insurance companies allow you, as the purchaser of the annuity, to mandate certain conditions. You could stipulate that your heir could only elect to receive their inheritance through monthly payments, rather than a lump sum which could be rapidly spent. Some of the income options include:

  • Single life (your heir receives payments for the rest of their life)
  • Life annuity with period certain in which your beneficiary receives monthly payments for the rest of their life. But, if they die within a certain time period, usually 5, 10, or 15 years, payments would continue to their beneficiary.
  • Joint and survivor (your beneficiary would receive a monthly payment for the rest of their life, and then their spouse would receive payments for the rest of his or her life)

A nice benefit of using an annuity to pass assets to a spendthrift heir is that there is no trustee. Your plan is actually enhanced by the fact that the annuity is issued by a faceless insurance company. There's no individual for your heir to complain to or ask for more money.

What are the disadvantages of using an annuity in a spendthrift heir situation?

The big drawback to using an annuity in this case is a lack of flexibility. The payment amounts are fixed by the annuity contract, and any restrictions you place (like the requirement to take payments over their lifetime). There isn't any room to fiddle with the payments.

There isn't a trustee who can assess your heir's financial situation and use wisdom and logic to determine if additional income is needed. You take all the human or emotional elements out of the equation when you pass assets through an annuity.

Another potential drawback is that the assets used to purchase the annuity won't experience investment gain. Assets held in a trust might be invested in bonds, stocks, or mutual funds. Checks would be written to your heir while the bulk of the funds remain invested.

On the other hand, using an annuity guarantees that no money will be lost due to market fluctuations. By definition, annuities provide a guaranteed income stream. This could save money on financial advice, and also eliminate any anxiety about the trustee or other investment manager losing money for the trust.

Make your choice as part of your overall plan

No matter how you think your spendthrift heir should be handled, make sure to talk to your estate planning advisors before you take any actions. They can review the specifics of your situation, including the number of heirs, as well as the size of your estate to determine if an annuity should be used for passing on assets. Always keep your advisors informed about your desires and circumstances.

Alliance America can help

An Alliance America financial advisor can assist you in maximizing your retirement resources and help achieve your retirement goals. Alliance America's planning process is focused on personalized retirement income planning. As fiduciaries, our advisors are required to act in your best interest, and we are dedicated to helping you achieve the retirement lifestyle you seek. You can request a no-obligation consultation by calling 888-864-2542 today.

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