4 Ways To Use Annuities In Your Estate Plan

When you think about estate planning, wills, trusts and life insurance usually top the list. But annuities deserve a spot in the conversation, too. Beyond providing reliable income in retirement, annuities can ensure your spouse keeps receiving steady checks, transfer wealth to heirs and help sidestep probate.

Still, annuities come with specific rules on taxes, ownership and fees. Missteps can lead to bigger tax bills or complications for your heirs. That’s why it’s critical to work with both a financial advisor and an estate planning attorney to make sure annuities fit your overall plan.

Each of these strategies comes with trade-offs, but when used strategically, annuities can add stability to an estate plan.

1. Secure guaranteed monthly payouts for your spouse

Estate planning isn’t just about leaving assets behind — it’s also about ensuring your loved ones can cover the bills after you’re gone. With a joint-life annuity, also called a joint-and-survivor annuity, your spouse keeps receiving payments from the insurance company if you die first.

A joint-life annuity comes with a couple key benefits:

• It ensures your spouse doesn’t suddenly lose income at the worst possible time.
• It helps reduce reliance on your spouse’s own savings or investments to cover ongoing bills.

But joint-life annuities come with a major trade-off to keep in mind: Payouts are lower than with a single-life annuity, since the insurance company is taking on more risk by guaranteeing payments for two lives instead of one. But for many couples, the peace of mind may be worth the smaller monthly check.

2. Leave an inheritance for your heirs

Annuities can also be structured to pass money directly to heirs. Instead of only functioning as retirement income, they can double as a legacy tool. The key is in the death benefit features.

Annuities can be structured with different death benefit options.

• Standard death benefit: Guarantees at least the original premiums (minus withdrawals) pass to heirs.
• Return of premium rider: Ensures heirs receive the full premium amount regardless of market conditions, though it typically costs 0.30 percent to 1.5 percent annually.
• Legacy or enhanced death benefit riders: These can grow the death benefit based on a guaranteed interest rate or step-ups at market highs.

“In terms of annuity death benefits, it’s possible to add some bells and whistles such as a certain period or refund provision,” says Scott Witt, an actuary and fee-only insurance advisor at Witt Actuarial Services. “But it comes with a price in the form of lower income payments.”

The death benefit from an annuity offers beneficiaries flexibility. Instead of a single lump sum, beneficiaries can choose to receive regular income payments. That not only helps with budgeting but also spreads out taxes over time.

For families where heirs might struggle with managing a windfall — or where tax efficiency is a concern — it’s worth exploring annuities as a wealth transferring estate planning tool.

3. Avoid probate

Probate — the court process of validating a will and distributing assets — is slow, expensive and public record. Annuities help avoid that headache because you can directly name a beneficiary. Instead of being tied up in court, the money flows directly to the beneficiary named on the contract.

However, if you don’t name a beneficiary, or if the beneficiary predeceases you in death and no contingent is listed, the annuity could end up back in the probate system. That’s why it’s crucial to review beneficiary designations regularly, especially after major life events like marriage, divorce or the birth of a child.

4. Transfer ownership to a trust

For more advanced estate planning needs, an annuity can be transferred to or purchased inside a trust. This move is complex and should only be done with legal and tax guidance, but it can offer several benefits.

• Asset protection: Trust-owned annuities are generally shielded from creditors and lawsuits.
• Flexible distribution: The trust can dictate how and when heirs receive income, preventing poor financial management or disputes.
• Tax planning: While transferring an existing annuity into a trust may trigger taxes, setting one up inside the trust from the start can offer more control over how taxes are handled later.

When you transfer ownership of an annuity into a trust, its existing value and any future earnings are no longer counted as part of your taxable estate. That’s a potential win for estate planning — but there’s a catch. Depending on how the transfer is handled, the IRS might consider it a taxable event, meaning you could owe income taxes on any gains the annuity has earned up to that point.

Another option is purchasing an annuity on the life of the beneficiary — rather than your own — inside a trust, says Witt.

“If there are concerns about an heir mismanaging a lump sum, then a trust could proactively purchase an annuity on the life of the beneficiary,” he says. “This would provide a guaranteed lifetime income and prevent a beneficiary from spending down an inheritance.”

Why go this route? When an heir inherits an annuity outside a trust, they typically have three options: take a lump sum, stretch withdrawals over five years or spread withdrawals over their own life expectancy. If you’re worried an heir will take the lump sum and blow through it, purchasing an annuity inside a trust gives you greater control over how — and when — that money is distributed.

Generally, qualified annuities — those funded with pre-tax dollars inside a retirement plan — shouldn’t be placed in a trust because of tax complications. Non-qualified annuities, funded with after-tax dollars, are usually more suitable.

It’s important to note that the IRS has strict rules about trust ownership of annuities, and violating these rules can result in unintended tax consequences. This is not a DIY estate planning strategy — it requires professional help.

Disadvantages of using an annuity in an estate plan

Despite their benefits, annuities aren’t an estate planning panacea.

One of the biggest drawbacks is cost. Riders with enhanced death benefits or guaranteed legacy growth often carry annual fees that can eat into your returns.

Another challenge is the way annuities are taxed. Unlike inherited stocks or mutual funds that may benefit from lower long-term capital gains rates or a step-up in basis, annuity payouts are taxed as ordinary income.

Annuities also tend to be a less tax-efficient way to transfer wealth than life insurance policies, says Witt.

“Life insurance inside of a trust may be able to escape estate and income taxation, whereas annuities — including inside of a trust — are generally going to have gains taxed as ordinary income,” says Witt.

For families prioritizing tax efficiency, this is an important factor to weigh.

Complexity is another major downside. Rules around trust ownership, required minimum distributions and gift tax exceptions can make annuities harder to manage than simpler accounts. If the estate plan doesn’t clearly spell out how the annuity fits into the overall strategy, it can cause confusion — or worse, conflict — among heirs.

In short, while annuities can add security and flexibility, they’re not a one-size-fits-all solution. Without careful planning and professional guidance, annuities can end up creating administrative headaches for your estate.

Bottom line

Annuities can be powerful estate planning tools when used strategically. They can provide guaranteed income, seamlessly continue monthly payouts for your spouse and bypass probate.

But they’re also complex and carry strict IRS rules. The key is integrating them into a well-documented estate plan that aligns with your broader goals.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.