Private annuity: When might it fit your estate or retirement plan?
A private annuity is a specialized financial arrangement, typically used to manage advanced estate planning and significant transfers of wealth. It involves moving assets outside of the taxable estate while creating lifetime income for the transferor.
While they remain a potentially powerful tool for estate planning, it’s best to think of private annuities in pre-2006 and post-2006 terms. In 2006, the Internal Revenue Service (IRS) proposed changes to the tax treatment for a private annuity, signaling a shift away from the prior deferral system.
This article explains how private annuities work, their pros and cons — including the impact of the 2006 IRS changes — and how to set one up.
What is a private annuity?
A private annuity is an agreement between two parties. The annuitant transfers an asset to another party — such as a family member or trust — in exchange for regular annuity payments.
Families and business owners have historically used private annuities — bypassing traditional annuities backed by insurance companies — to help accomplish two main goals:
- Estate tax planning: A private annuity removes the asset being transferred from the annuitant’s taxable estate, helping to shield its future growth from estate taxes.
- Wealth transfer: A private annuity can help optimize planning for retirement.
Private annuities typically use a grantor trust, such as a private annuity trust, to formalize the arrangement and ensure compliance. The trust receives the asset and assumes responsibility for making the regular payments to the annuitant.
How a private annuity works: Mechanics and calculation
Setting up a private annuity for estate planning requires several steps. Pay attention to the following to avoid tax or legal problems. These are complex products that should involve the appropriate professionals.
- Set parties and objectives: First, you designate the two parties — the annuitant and the transferee. In conjunction with your lawyer and advisors for taxes and financial planning, you define the primary objective of the private annuity. This may include reducing estate taxes, transferring wealth, or creating an income stream in retirement.
- Value assets: To help avoid gift tax treatment, ensure the value of the annuity payments equals the value of the transferred asset. As long as the values align, the IRS typically doesn’t consider the asset a gift.
- Choose payment basis/determine interest rate: Unless the annuitant is terminally ill, you’ll typically use IRS-approved actuarial (life expectancy) tables to determine the frequency and amount of the payments. IRS section 7520 guides the interest rate (discount rate) used to calculate the present value of future annuity payments.
- Compute payment schedule and model taxes: After determining the required size of each annuity payment using the asset’s value, the annuitant's life expectancy, and the section 7520 interest rate, model the tax treatment based on current guidance, including capital gains on the transfer and ordinary income.
- Draft legal agreement and trust docs: This step formalizes the pact with an official document that outlines the responsibilities of both parties, the specifics of the asset transfer, and the annuity payment schedule.
- Ongoing admin: The transferee or trust has the responsibility to maintain ongoing administration of the private annuity agreement, which includes annual tax reporting and distribution of timely annuity payments.
Pros and cons of private annuities
Private annuities can be a great wealth management tool for clients with large taxable estates, but they come with potential drawbacks.
Pros
- Estate removal: When you transfer an asset using a private annuity, it’s removed from your taxable estate. This means you can reduce or eliminate the estate tax on the asset, including on its future growth.
- Custom terms and control: You can customize the terms of your private annuity in ways you can’t in the commercial market. Families can negotiate payment schedules and growth or inflation rates prior to signing a contract as long as they stay within the bounds of government regulations.
Cons
- Loss of tax deferral: Before 2006, capital gains on appreciated property exchanged for a private annuity could be spread over the annuitant’s life expectancy. Proposed regulations in 2006 eliminated this benefit. Although the rules were never finalized, they reflect the IRS’s position against deferral.
- Trustee/admin costs: If you have a relatively small estate, the costs to maintain a private annuity agreement could outweigh the benefits. Given the complex nature of the arrangement, you’ll likely need to hire financial and legal professionals as well as an administrator to handle ongoing management.
How to set up a private annuity
Once you know how a private annuity works, you must focus on execution to mitigate legal risk and tax consequences. Here are the steps to help involved in setting up a private annuity. Since this is a complex process it is recommended starting with seeking professional legal, tax and financial advice.
Determine the asset and finalize valuation
Select the asset you intend to transfer, such as real estate, closely held business interests, or investment property. Hire a qualified appraiser to establish its fair market value. This is important because it sets the capital gains liability and ensures the IRS doesn’t treat the transfer as a gift.
Model annuity payments and sign a private annuity agreement
Working with an advisor, calculate annuity payments based on the asset’s value and IRS rules. Once the terms are finalized, sign a binding agreement that specifies the parties, payment schedule, and obligations. From here, you sign an irrevocable agreement, typically placing the asset in a trust in exchange for the legally binding requirement of the annuity payments.
Understand tax implications and ongoing obligations
The IRS requires the annuitant to report taxes in three parts:
- The return of your principal investment, or cost basis, is not taxable.
- The IRS taxes the gain you realized from the asset transfer at the capital gains tax rate.
- Any interest earned on future annuity payments gets taxed by the IRS at ordinary income tax rates.
Here’s a general hypothetical example of how this looks in practice.
You (the annuitant) transfer an asset with a fair market value of $1,000,000. You paid $500,000 for it. The $500,000 gain is taxable capital income. Under the 2006 proposals, it would be reported immediately at transfer, not spread over your life expectancy.
What is a custodial-owned annuity?
A custodial-owned annuity is a commercial product held by a third-party custodian, usually a parent for the benefit of a minor. The custodian manages the contract until the child reaches the age of majority and can legally take control of the account. Depending on the state of residence, this could be at either 18 or 21, with some states, such as California and Florida, allowing for an extension to 25.
Taxation for annuities held in custodial accounts can be complex. Depending on your specific situation, either the minor or the custodian will be responsible for taxes on any income generated.
Simplify estate planning with Gainbridge
While a private annuity can be a powerful estate planning tool for wealthy individuals looking to escape the gift tax, the IRS removed a large benefit in 2006. Private annuities have become less attractive because the annuitant would owe capital gains tax on the fair market value minus cost basis of the transferred asset.
Most investors nearing retirement have two primary concerns: steady growth of their nest egg and a guaranteed income stream. You don’t want to run out of money and you want something left to pass on to your estate.
To eliminate the stress of market volatility and complicated legal and tax implications, consider fixed annuities from Gainbridge. In addition to principal protection and a set interest rate, Gainbridge annuities guarantee a stream of retirement income without the high administrative costs.
Explore Gainbridge today to learn how our annuities — with no hidden fees and commissions — can help you build a flexible retirement strategy that can protect you and your family with guaranteed payments.
This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes. Guarantees are backed by the financial strength and claims-paying ability of the issuer.
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