Part of a parent’s concern when amassing assets is how best to transfer those assets to the next generation. There is the ever-looming question of how tax obligations will figure into the equation when you pass on wealth. You want your children to enjoy the financial legacy you have provided for them, but you don’t want to cause them any hardship because of the taxes they will owe.

If you are looking to increase your estate assets and don’t need additional income, you can achieve your goal by funding a trust with a deferred annuity. This strategy may allow your heirs to defer taxes on the money inside the annuity, which allows the trust assets to continue appreciating on a tax-deferred basis. Keep in mind that annuity payments may be taxable to either the trust or the trust’s beneficiary, if the trust is required to pay out yearly income. However, if the beneficiary takes over ownership of the annuity contract in the future, they are not immediately liable for taxes on the value of that contract. This change in ownership is what is known as an “in-kind distribution.” The new contract owner inherits the cost-basis value of the annuity, but doesn’t receive a step-up in tax basis on the original owner’s death. With a stepped-up cost basis treatment, any tax obligation on asset appreciation during the original owner’s lifetime is forgiven and the heirs’ cost basis would be the value of the asset on the original owner’s date of death.

Though the new contract owner may not receive this tax advantage, there are other important benefits with this strategy. First, the annuity is not subject to taxation as long as the new owner does not receive cash from it. Secondly, when the new owner does decide to draw an income from the annuity, they are taxed at their own tax rate, and not at the tax rate of the trust. For 2007, trusts are taxed at a rate of $2,701 on the first $10,450 and 35% on anything above that. Deductions and personal exemptions cannot be taken by the trust itself. This makes a trust’s tax rate substantially higher than that of the individual.

If you are considering this type of wealth transference strategy, there are several issues to consider. This is not a good option for those needing current income from the annuity. Withdrawals from an annuity may result in as much as a 10% IRS penalty for those under the age of 59 ½ in addition to possible surrender fees imposed by the insurer. Of course, it goes without saying that any annuity guarantee is dependent upon the financial strength of the insurance company that wrote the contract. This is why you need to be sure that you are dealing with an insurer with a sound financial history. It is also important to seek professional advice about the tax and legal implications of any annuity before you purchase the contract.

Be sure to seek the advice of a qualified legal and/or tax professional before moving forward with any estate planning strategy.

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