Should Annuities Be Put in a Trust? Tax Traps and Exceptions

Putting an annuity in a trust is usually a tax mistake unless the trust is a revocable living trust. Federal tax law penalizes annuities owned by entities that aren’t living people, and a trust is exactly that kind of entity. A revocable living trust sidesteps the penalty because the IRS still treats you as the owner. Every other trust structure either strips the annuity of its tax deferral or forces the money out on a punishing schedule after your death. Whether the estate-planning control is worth that cost depends on what problem you’re actually trying to solve.

Why the Tax Code Punishes Trust-Owned Annuities

The whole issue traces to one provision. If an annuity contract is owned by anyone other than a natural person, the contract loses its status as an annuity for tax purposes, and the annual investment gains are taxed as ordinary income each year, whether or not any money is actually withdrawn.¹ A trust is not a natural person. So when a trust owns an annuity outright, the IRS treats every dollar of annual gain as taxable income, wiping out the tax deferral that made the annuity worth buying.

The statute leaves one opening. If the trust holds the annuity “as an agent for a natural person,” the non-natural person rule doesn’t apply.¹ Whether your trust qualifies for that exception is the whole ballgame.

Revocable Living Trusts Keep the Deferral

A revocable living trust is the one structure that reliably preserves an annuity’s tax-deferred growth. Because a revocable trust is a grantor trust under federal tax law, the IRS looks through the trust entity and treats you, the grantor, as the owner of everything inside it. For income tax purposes the trust is invisible while you’re alive. That’s enough for the annuity to qualify under the agent-for-a-natural-person exception, and the contract keeps its tax treatment.

Nothing changes about how the annuity is taxed during your lifetime. You keep full control because you can amend or revoke the trust whenever you want. At your death, the annuity passes to your beneficiaries through the trust and skips probate, which avoids court costs, delays, and the public disclosure of your assets. If probate avoidance is the main reason you were considering a trust in the first place, a revocable living trust is usually the cleanest fit.

The trade-off is that a revocable living trust offers no creditor protection during your lifetime and limited protection after your death. The assets are still considered yours for lawsuits, Medicaid eligibility, and estate taxes. The moment you need more than probate avoidance, you’re looking at irrevocable trusts, and that’s where the tax picture gets ugly.

Irrevocable Trusts Destroy Deferral and Trigger Compressed Brackets

An irrevocable trust that isn’t a grantor trust fails the agent-for-a-natural-person exception. The moment a non-grantor irrevocable trust takes ownership of an annuity, every dollar of annual gain becomes taxable ordinary income on the trust’s own return.¹ The contract still exists. It just no longer offers any of the tax advantages that justified buying it.

Then it gets worse. Trust income tax brackets are dramatically compressed compared with individual brackets. For 2026, a single individual doesn’t hit the top 37% federal rate until income exceeds $640,600.² A non-grantor trust hits that same 37% rate once income exceeds just $16,000. An annuity throwing off $50,000 of annual gains inside a non-grantor irrevocable trust would owe roughly $16,400 in federal tax on those gains. The same $50,000 in the hands of an individual beneficiary in the 22% bracket would produce roughly $11,000 in tax. That gap compounds year after year, turning the trust into an expensive container for an asset designed to defer taxes, not accelerate them.

Naming a Trust as Beneficiary Instead of Owner

A more common approach is to leave yourself as the annuity’s owner and name a trust only as the beneficiary. This avoids the non-natural person problem while you’re alive, so the annuity keeps its tax deferral until you die. The complications show up when the trust actually inherits the proceeds.

The Five-Year Rule

Inherited non-qualified annuities follow their own distribution rules, separate from the rules that apply to IRAs and workplace plans. If the annuity owner dies before the annuity starting date, the entire balance must be distributed within five years.³ If the owner has already begun annuitized payments, the remaining payments must continue at least as quickly as they were being made.

The statute allows a life-expectancy stretch for a “designated beneficiary,” but it defines that term narrowly as “any individual designated a beneficiary by the holder.”³ A trust is not an individual. Unlike the IRA rules, where Treasury regulations let certain “see-through” trusts count as designated beneficiaries, no equivalent regulations exist for non-qualified annuities. A trust named as beneficiary of a non-qualified annuity is stuck with the five-year rule.

A lot of planning material gets this wrong. The 10-year distribution rule created by the SECURE Act applies to IRAs and qualified retirement plans, not to non-qualified annuities. The see-through trust and eligible designated beneficiary concepts also belong to the qualified plan world. Applying those rules to a non-qualified annuity produces bad planning decisions.

Why the Five Years Hurt

Squeezing an entire annuity balance into five years of taxable distributions creates a concentrated tax hit. A $400,000 annuity with $250,000 of gain paid out over five years generates $50,000 of taxable income per year from that annuity alone. At trust tax rates, nearly all of it lands in the 37% bracket. The trustee can distribute the income out to individual beneficiaries to shift the tax onto their personal returns, but the five-year window still forces far more income per year than a life-expectancy payout would.

What Naming an Individual Would Have Done Instead

When you name a person directly, that person qualifies as a designated beneficiary and can elect to take distributions over their own life expectancy, as long as payments start within a year of your death. A 45-year-old beneficiary can spread distributions over roughly 38 years. A surviving spouse gets even better treatment: the tax code lets the spouse step into your shoes and continue the contract as if it were their own.³ The tax savings are real. What you give up is control.

No Step-Up in Basis, Ever

Some people assume routing an annuity through a trust at death resets its cost basis and erases the accumulated gains. It doesn’t. The tax code specifically excludes annuities from the stepped-up basis that applies to most inherited property.⁴ All the deferred gain is income in respect of a decedent and stays taxable to whoever receives it, trust or individual. No trust structure, transfer, or death event eliminates that tax. The only levers you have are when it gets paid and at what rate.

When a Trust Is Worth the Tax Hit

Some situations do justify accepting the tax cost. The common thread is that the beneficiary needs protection from themselves, from others, or from circumstances that make direct access to a large lump sum dangerous.

Special needs beneficiaries. Someone receiving SSI or Medicaid could lose eligibility if they inherit an annuity outright. A properly drafted special needs trust holds the proceeds and pays for supplemental expenses without disqualifying the beneficiary from public benefits. The five-year timeline is an inconvenience; losing government benefits would be much worse.
Minor children. An annuity carrier won’t pay a death benefit directly to a child. Without a trust, a court-appointed guardian manages the funds with ongoing judicial oversight and expense. A trust names your trustee and dictates how the money is used.
Beneficiaries with addiction, creditor, or judgment problems. An irrevocable trust with a spendthrift clause can shield annuity proceeds from a beneficiary’s creditors and stop the beneficiary from pledging or assigning their interest. Protection varies by state, but a properly drafted spendthrift trust usually keeps assets out of reach of personal creditors.
Blended families. When you want a surviving spouse to receive income during their lifetime but want the remainder to go to children from a prior marriage, a trust can enforce that sequence in a way a beneficiary designation on the contract cannot.

In each case the trust is solving a problem the annuity contract can’t solve on its own. The tax cost is the price of that solution.

Medicaid, 1035 Exchanges, and Getting the Paperwork Right

If you’re considering an irrevocable trust as part of long-term care planning, Medicaid’s 60-month look-back applies. Transferring an annuity into an irrevocable trust inside that window and later applying for Medicaid-funded nursing home care will be treated as a disqualifying transfer, triggering a penalty period based on the value transferred divided by the state’s average monthly nursing home cost. Annuity income paid from a trust to or for a Medicaid applicant also counts toward Medicaid’s income limits, which can independently disqualify someone. The strategy only works if you’re planning at least five years ahead.

If a trust already owns an annuity and you want to swap it for a better contract, the tax code allows a tax-free exchange of one annuity for another as long as the owner stays the same.⁵ The trust that owned the old contract must own the new one. You can’t use the exchange to move ownership from the trust to an individual or the other way around without triggering tax.

Titling matters more than people expect. When a trust owns an annuity, the contract must be in the trust’s legal name, not the trustee’s personal name, typically formatted as “The [Name] Trust, dated [Date].” Carriers can be strict about this, and a mismatch between the trust document and the annuity application can create ownership disputes after death. When naming a trust as beneficiary, the designation must reference the trust’s full legal name and date. Vague language like “my family trust” invites litigation.

Administration costs add up. For a non-grantor trust that owns an annuity, the trustee has to calculate and report annual income on the trust return and track cost basis for future distributions. Professional trustees typically charge between 0.6% and 2.0% of trust assets per year, and small trusts often face minimum fee schedules that eat into modest balances. Those fees stack on top of the annuity’s own mortality and expense charges, investment fees, and rider costs.

Qualified Annuities Follow Different Rules

Everything above applies to non-qualified annuities, which you buy with after-tax dollars outside a retirement account. Annuities held inside IRAs or employer plans follow a different set of post-death distribution rules that impose a 10-year deadline for most non-spouse beneficiaries and do allow certain see-through trusts to look through to the underlying beneficiaries for timing purposes.⁶ Longer periods can apply for trusts whose sole beneficiaries are eligible designated beneficiaries, including surviving spouses, minor children, and disabled or chronically ill individuals. To qualify, the trust must be valid under state law, become irrevocable at or before the account owner’s death, and have identifiable beneficiaries whose documentation has been provided to the plan administrator.⁷ If your annuity is inside an IRA, those rules govern instead of the ones covered here.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: Treatment of Annuity Contracts Not Held by Natural Persons
2
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments from the One Big Beautiful Bill
3
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: Required Distributions Where Holder Dies Before Entire Interest Is Distributed
4
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
5
Internal Revenue Service. Part I Section 1035 – Certain Exchanges of Insurance Policies
6
Internal Revenue Service. Retirement Topics – Beneficiary
7
Internal Revenue Service. IRS Letter Ruling 201320021