Dream of Funding Granddaughter’s Education Became Annuity Nightmare

Q. In July 1990, my father, at an insurance agent’s urging, opened what was supposed to be a college fund for my then-2-year-old daughter. He put $5,000 into the account, which was set up with an insurance company under the California Uniform Transfers to Minors Act, with me listed as the custodian and my daughter as the annuitant. I recently learned the investment is actually a non-qualified variable annuity, which is a retirement fund, and that if I withdraw this money before my daughter turns 59 1/2 I will be subject to a large tax penalty. The insurance company refuses to help me or correct the error of the agent, who knew that this account was being set up for my daughter’s college education. What are my options? Can I transfer this account to my name and keep it as a retirement account for myself and avoid the high tax penalty? (I am 38 now.)

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A.It sounds as if your father was sold an unsuitable investment by an insurance agent interested only in a fat commission. Instead of correcting the error at once, the insurance company turned its back on you.

It’s time to raise hell.

Your insurance company initially argued that since you signed the papers to become the custodian, you should have known that the annuity your dad was sold is intended for retirement, not college planning. But the account was titled as an UTMA--which means it has to be paid out by the time a minor is 25, at the oldest. (State laws vary, with some requiring payouts at age 18 or 21; California allows an extension to age 25.) So the insurance company, which is far more savvy than the average consumer about annuities, should have known this was an inappropriate investment.

The main advantage of an annuity is that you don’t have to pay taxes on your investments until you pull the money out. But as an UTMA, the account already enjoys a built-in tax advantage. Any investments held in an UTMA would be taxed at your daughter’s rate, which means the first $700 in earnings wouldn’t be taxed at all, and the next $700 would be taxed at 15%. (If there were more than $1,400 in earnings, the excess would be taxed at your rate.) Annuities make little sense for most people, but they make no sense when your tax bracket is low.

The agent who sold this loser might also argue that your father was told about the 10% early- withdrawal penalty and chose to use the retirement account anyway, figuring the tax-deferred features of the variable annuity would outweigh the eventual penalty. But if you talk to your father, I’ll bet he doesn’t remember his agent bringing up the issue at all.

Agents often sell annuities to unsophisticated investors by touting their tax-deferred advantages, neatly neglecting to mention the serious drawbacks involved.

Fortunately, this story has a happy ending.

You were trying to deal with the insurance company’s customer service department. I called the company’s public relations office, and they responded with alacrity. They admitted your dad was sold the wrong product, and they have promised to make you whole by paying the 10% penalty and whatever income taxes you incur.

If the company had continued to be reticent, we could have called in the regulatory cops. The California Department of Insurance, which is listed in your phone book’s blue pages, is charged with protecting consumers from such abuses.

You didn’t have many other options with this account, by the way. By law, you can’t hang on to UTMA money once your child is grown, and you can’t switch the money to your name.

Home Transfer Not so Clear-Cut

Q. I’m a tax and estate-planning attorney and must take issue with your Dec. 20 column about the woman whose father deeded his home to her brother. You said that when the brother sold the house after the father’s death, the taxes would be based on the father’s tax basis, or what the home cost the father plus the cost of any improvements over the years. But if the father continued to live in the house, it would be included in his estate and the brother would indeed get a step-up in tax basis to the home’s fair market value on the date of the father’s death.

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A.You’re right. I assumed the father spent his last months in a nursing home, but even that might not make the transfer as clear-cut as I indicated in the previous column.

I also blew it on the issue of what qualifies for probate. In general, assets worth more than $100,000 must pass through formal probate proceedings in California unless specific probate-avoidance measures have been taken. But that limit is lowered to $20,000 when real estate is involved.

Liz Pulliam is a personal finance writer for The Times. Send questions for this column to [email protected] or mail them in care of Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.