A private annuity can be powerful for transferring wealth and planning your estate. It’s an agreement where one person transfers assets for a guaranteed stream of payments. Unlike traditional annuities, a private annuity is often used between family members. It's a unique solution for preserving wealth within a family.
Understanding how a private annuity works can help you decide if it’s right for your financial situation. It can offer potential tax benefits and provide a way to reduce estate taxes. For those looking to plan ahead, knowing the ins and outs of this arrangement helps you make an informed decision. They may be key to your financial planning strategy.
What Is a Private Annuity?
A private annuity in estate planning is a special financial arrangement like a traditional annuity. It occurs between two parties, usually individuals, rather than with an insurance company. In this setup, one person, the annuitant, transfers assets to another person, the obligor.
The annuitant makes the exchange of assets for a fixed, periodic payment for the rest of their life. Examples of assets include real estate or stocks. Families sometimes use private annuities in estate planning to transfer wealth.
Unlike traditional annuities, a private annuity is more flexible. You can use custom payment terms without locking into commercial products terms.
How Does a Private Annuity Work?
A private annuity in estate planning has a fairly straightforward process. Here’s how it typically works:
- The person setting up the annuity (the annuitant) transfers assets to another party (the obligor).
- The transfer is made in exchange for a promise of lifetime payments.
- The obligor agrees to make regular, fixed payments to the annuitant for the rest of the annuitant’s life. These payments can be monthly, quarterly, or annually, depending on the agreement.
- The amount of the payments is determined based on factors. Factors include life expectancy, the value of the assets, and the interest rate.
- Once the annuitant passes away, the payments stop, and there is no further obligation to the obligor. This differs from traditional annuities. They may have an annuity death benefit or continued payments to beneficiaries.
The value of the transferred assets, the IRS’s life expectancy tables, and IRS Section 7520 interest rates are used to figure out how much the annuity payments will be. Once the interest rate and payment amounts are set, they typically can't be changed. If the annuitant dies earlier than expected, the person making the payments might end up paying less than planned.
A private annuity is often held in a trust (private annuity trust) which can operate as its own business for tax purposes. However, there are some restrictions when using grantor trusts for this purpose.
In 2006, the IRS changed the rules. They require that any sale of assets as part of the annuity be taxed as a capital gain at the time of transfer. This removes the option for a non-taxable sale.
Private Annuity Examples
A key aspect of a private annuity is that it’s not bound by the rules of commercial annuities. You have more flexibility in terms and structure.
However, the obligor assumes the risk if the annuitant lives longer than expected. The obligor must continue payments for as long as the annuitant lives. You can implement this many ways.
Take a look at this private annuity example:
If you have children, you might transfer real estate to them. In return, you'll receive lifetime payments. This removing the property from their estate and potentially reducing estate taxes.
Let’s look at another private annuity example:
What if you own a small business and you want to pass it on to someone. You can use a private annuity to transfer it without selling or gifting the asset. You’ll work with your financial advisor and estate planning attorney to determine the value of the asset and draft a private annuity contract.
You can use a private annuity calculator to get an idea how much guaranteed income you’ll receive. When you retire and are no longer running your business, the obligor can take over and you’ll receive your regular payments until you pass away.
How to Set Up a Private Annuity
Setting up a private annuity involves several steps, but with careful planning, it can be a smooth process. Here’s a step-by-step guide to help you get started:
- Identify who you are transferring assets to. Typically, this arrangement is between family members, such as parents and children.
- Determine the fair market value of the assets you want to transfer. Accurate valuation will impact the annuity’s payment calculations and ensure they follow IRS regulations. Consulting a certified appraiser can help with this step.
- Let experts draft a legal agreement. Work with a financial planner and estate planning attorney to draft a formal contract. They will work together to create the terms of the private annuity. The agreement should include details like:
- value of the transferred assets
- payment amounts
- payment frequency
- payment duration (usually for the annuitant’s lifetime)
- interest rates
- Once the agreement is in place, transfer the ownership of the assets to the obligor. This could include deeds for real estate, stock certificates, or other assets. Experts should document the transfer so there are no issues with future tax filings.
- The obligor should start making the agreed-upon payments to the annuitant.
Benefits of a Private Annuity
A private annuity in estate planning has many advantages:
- You don't pay estate taxes. Remember, you're transferring assets out of your estate in exchange for annuity payments. This means the value of those assets is removed from your taxable estate.
- You don't pay gift taxes. A private annuity is not considered a gift for tax purposes.
- You gain a new retirement income stream. This is steady income for life. This is useful is you don't want the management burden of owning certain assets, like real estate.
- You have more control in a private process. A private annuity allows for custom payment arrangements.
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Any comments regarding safe and secure investments and guaranteed income streams refer only to fixed insurance products. They do not refer in any way to securities or investment advisory products. Fixed insurance and annuity product guarantees are subject to the claims paying ability of the issuing company; not guaranteed by any bank or the FDIC.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Stewart Willis, providing such comments, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), an SEC registered investment adviser or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment, legal or tax advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Personal investment advice can only be rendered after the engagement of Foundations for services, execution of required documentation, including receipt of required disclosures. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Any statistical data or information obtained from or prepared by third party sources that Foundations deems reliable but in no way does Foundations guarantee the accuracy or completeness. Investments in securities involve the risk of loss. Any past performance is no guarantee of future results. Advisory services are only offered to clients or prospective clients where Foundations and its advisors are properly licensed or exempted. For more information, please go to https://adviserinfo.sec.gov and search by our firm name or by our CRD # 175083.
