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Get Smart About Annuities in Special Needs Planning

Among Saturday Night Live’s (SNL’s) parody ads is one for “Alexa Silver”. You can watch the whole thing here. (Note: language and humor are typical SNL and may not be 100% politically correct). There is another parody ad for Alexa on the YouTube channel “It’s a Southern Thing”. Both parodies have the same punchline. Alexa, which is generally marketed as the smart speaker that can do everything from turning on your lights to ordering your groceries to answering random trivia, does not work equally well for all people in all circumstances. No solution is “one size fits all”, and thus there is no one answer for similar questions. Instead, each demographic group needs to consider whether a particular answer or solution is useful, given that every one has inherent limitations.

Many people are concerned that they will spend their retirement funds too quickly and that the funds will not last as long as they do. An annuity is an insurance product that creates a lifetime of income payments from a lump sum in order to address this very concern. On the surface, then, an annuity could be the perfect solution to the potential problem of outliving one’s assets. If you purchase an annuity, not only will the insurance company apportion your assets across your expected lifetime, but if you live longer than expected, the insurance company is, by most contracts, committed to continuing to pay you even if your initial investment has been exhausted. Not surprisingly, some people have considered whether an annuity could be a useful tool for special-needs planning. After all, the main objective of parents who have a child with a disability is to make sure that the assets they leave to the child continue to supplement the child’s needs for his or her whole life.

The problem is that annuities have certain features that can make them less effective for a person with a disability, who cannot exceed a certain amount of income or assets if s/he wants to maintain Medicaid to cover health insurance and services. To understand how and when these difficulties may arise, it is helpful to understand a few of the unique features of an annuity. For the purposes of this article, we will assume the annuity in question has not been purchased with pre-tax funds, as an IRA. In this case we are presuming, money contributed by the owner to the annuity is after-tax money and thereafter represents the annuity’s cost basis. The funds are invested inside the annuity and grow tax-deferred. When funds are removed from the annuity, the portion of each payment that represents the basis is not taxed, but the portion that represents the investment growth is taxed. If the annuity is turned into a stream of periodic payments, a portion of each payment represents a return of the basis, and a portion represents the earnings. When the periodic payments are spread over a long time, the tax burden is likewise stretched over many years. But in some cases, the funds must be removed from the annuity much more quickly, resulting in a large tax burden over a short span of time.

There are three parties to any annuity: the owner, the beneficiary, and the annuitant. The owner is the person, who purchased the annuity contract, and who is authorized to make any decisions or changes that affect the contract. For example, the owner can change the way the contract funds are invested. The owner can also change the beneficiary. Since annuity contracts are insurance products, they all have death-related benefits and beneficiaries. Similar to the beneficiary of a life insurance policy, the beneficiary of an annuity receives the funds remaining in the contract when the owner dies. The annuitant, however, is the person, who receives periodic payments from the contract, and whose lifespan is used to calculate how much per period a lump sum will generate in period payments.

In a typical retirement scenario, the owner and annuitant are often the same person. For example, if I want to use an annuity contract to make sure my retirement assets are stretched over my entire post-retirement lifetime, I would use some of my retirement savings to purchase an annuity, and I would be both the owner and the annuitant. Typically, my spouse (if I have one) and/or my children (if I have them), would be the beneficiaries. Once I retire, I would begin to take periodic payments from the annuity contract, and if I died before the contract funds were exhausted, the remainder might be paid out to my beneficiaries. It can get more complicated than that, since certain contracts don’t pay out anything if the contract has been annuitized (meaning a certain method for generating periodic payments has been applied) and some contracts will pay a remainder sum, even if the funds have been exhausted. But that is the general idea.

This structure, though, poses certain difficulties in special-needs situations. First of all, who should be the owner in this case? If the person with a disability is the owner, then the annuity is her/his asset, and it very probably will exceed Medicaid’s countable resource limit. Once the asset is turned into periodic payments, which, after all, is one of the main advantages of an annuity, then the payments become unearned income to the person with a disability and are very likely to exceed Medicaid’s income limit. If the parents of the person with a disability own the contract, they could still designate the person with a disability as the annuitant to receive periodic payments, based on her/his life span. In this case, the asset would not be a hindrance to Medicaid. The parents, as owners, would likely be responsible for the tax owed on the income once the contract begins to pay out.

Although this arrangement would seem to avoid several pitfalls, it still poses some potential difficulties. First of all, some annuity contracts are structured such that once the annuitant begins to receive peridic payments, she/he also becomes the owner of the contract and thus liable for the taxes. This change could also endanger the person’s Medicaid eligibility because now, as in the first example, the person with a disability is receiving regular, unearned income. The second difficulties arise if the parent-owners die before the contract has begun to make periodic payments. In this case, the entire value of the contract becomes payable not to the the person with a disability who is the annuitant, but rather to the contract beneficiaries; for example, a sibling of the person with a disability. If the beneficiary has good intentions, s/he might be perfectly willing to use the funds on behalf of the person with a disability but any beneficiary who is not a spouse of the owner might be required to remove the fund from the annuity over a short period of time and would thus face a hefty and accelerated income tax bill. The IRS would end up getting a lot of the benefit.

Another possibility would be to have a special needs trust own the annuity. The person with a disability would still be the annuitant, with a third party as the beneficiary. The annuity would not be considered an asset for Medicaid purposes, because it is owned by the special-needs trust, not directly by the person with a disability. However, the problem is in this case that when the annuity begins to pay out, the income portion of each payment becomes taxable to the trust, which pays at much higher rates than a low-income individual such as the person with a disability. There is a feature that allows special-needs trusts to pass on income from the trust to the beneficiary. Any income passed through in this way is reported by the beneficiary and thus taxed at her/his rate. But that same income thus becomes countable unearned income for Medicaid purposes and, if high enough, could jeopardize the Medicaid status of the annuitant who is the person with the disability.

Neither Alexa nor any other smart speaker can answer all questions accurately under all conditions and, for some more complicated questions, it is probably better to do one’s own research or talk to a live human being with specialized knowledge. Similarly, it is important to do your own investigation and consult with trustworthy financial and insurance professionals to make sure the resources you leave to your family member with a disability are sufficient to assist her/him for life.

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