Inherited Annuity

Know your inherited annuity options to discover the tax savings

We often get calls for advice when someone inherits an annuity. That’s understandable, it’s hard to wrap your head around annuities in the best of times, but after the death of a loved one, the task becomes even more challenging. The different inherited annuity options and rules are complicated. Here’s a closer look at the decisions you’ll have to make.

What is an annuity?

The first step is to understand what you’re inheriting. Annuities are insurance contracts. They’re an investment that can generate regular income payments that have certain guarantees from the insurance company. Although there are different types of annuities, they fall into one of two camps, qualified or non-qualified.

Qualified Annuity: Contributions are pre-tax, and distributions are taxable income. If you withdraw funds before age 59½, there is a 10% penalty, and you must begin required minimum withdrawals when you turn 70½. Sound familiar? Yes, 401(k)s, 403(b)s, and IRAs can hold annuities.

Non-Qualified Annuity: Contributions are after-tax, but growth/earnings are tax-deferred. This results in a mix of taxable (earnings/growth) and nontaxable (contributions) distributions. Unlike the qualified annuity, there is no restriction on taking funds out before age 59½, nor are you required to withdraw funds after 70½.

The annuitization exception

I need to back up a bit. In the definition of an annuity, I mentioned the ability for the owner to receive “regular income payments that have certain guarantees.” That, my friends, is called annuitization.

If the annuity owner has annuitized, they have traded the account value in the policy for a guaranteed income stream. At that point, there is no cash value to inherit, and you’re limited to the beneficiary payout option the owner selected if there is one. The usual annuitization options available are:

Life Only: There is no beneficiary. Payments end when the annuitant passes away. No inheritance for anyone!

Life with Period Certain: This option provides a guaranteed number of payments, typically for 10 or 20 years. For example, if the owner selected “10 year period certain,” payments will continue until the owner passes away or for ten years, whichever is longer. If the annuitant dies after five years, the beneficiary(ies) will receive the remaining five years of payments.

Joint and Survivor: Payments continue to the surviving designated beneficiary (typically a spouse). The payments end when the surviving beneficiary dies.

Annuities have additional options, called riders, so even with the above payout options if there is an additional death benefit rider, you might receive an inheritance, but the contract/rider may limit your choices in receiving the payout.

A non-annuitized annuity (try to say that 3x)

If the decedent passes away and they didn’t annuitize, you’ll inherit the cash value of the annuity. The beneficiary has several options regarding how to receive the inherited annuity, depending on your relationship to the annuity owner, spouse or non-spouse. You also must keep the tax implications of distributions in mind as you review the options. It’s worth a repeat:

Qualified Annuity: Distributions are 100% taxable income.
Non-Qualified Annuity: Distributions are a mix of taxable (earnings/growth) and nontaxable (contributions).

Non-spouse options

1. Five-year rule: The distribution of the entire balance of the annuity must take place within five years of the owner’s death. It doesn’t matter if you take all the proceeds in year one, two, five, or spread them out over each of the five years.

Since a qualified annuity is 100% taxable, if the value of the annuity is significant, even spreading it out over five years could create a tax burden. On the other hand, with non-qualified annuities, the first distributions are considered earnings and will be taxable until depleted. Eventually, the tax-free contributions will be left, and they are tax-free, but it’s a front-loading of taxation.

2. Lump Sum: You can get it all at once and pay all the taxes at once. It’s straightforward, but all that income in one year could be a tough tax pill, I mean bill, to swallow.

3. Stretch: The beneficiary can spread the inheritance distribution over their lifetime. It requires an easy, annual calculation of the beneficiary’s remaining life expectancy and the value of the annuity. The stretch is an impressive strategy for both qualified and non-qualified annuities for a number of reasons:

  • It spreads and probably reduces the tax pain over many years. Instead of taking larger distributions in big chunks over a shorter period, which can bump you into a higher tax bracket, you can receive smaller distributions over a longer period. Like the five-year rule, the first distributions in the stretch are considered earnings and will be taxable. When they are depleted then the tax-free contributions are distributed.
  • Continued investment growth! By taking smaller distributions, more of the money can stay invested. It can potentially increase and extend your inheritance, all while saving taxes.
  • As long as you take at least the minimum distribution, there are no adverse tax consequences. You can also always take more than the minimum as well.

4. Annuitization: You may also annuitize the annuity. You select a single-life payout or a term-certain-only option that is shorter than your life expectancy, the options mentioned previously in the annuitization section. There are positives:

  • You have a guaranteed payment spread out over your lifetime spreading out the tax liability.
  • If you annuitize a nonqualified annuity, part of the payment is a return of the contributions, which is tax-free. The other part is considered the gain and is taxable. The tax is not front-loaded when you annuitize.

But (you knew there was a but coming) you give up the cash balance for a guaranteed payment. If you need more than what the annuity pays out, then tough #$@#%, that’s all you get. This my least favorite option because it’s too limiting.

On the other hand, if you’re afraid you’re going to run out of money, lack discipline, or if it makes you feel better knowing you have a guaranteed monthly payment, then annuitizing is appropriate.

Spousal inheritance

A spouse has all of the above options, plus…

Spousal Continuance: A spouse can continue the existing contract and treat the annuity as their own and name a new beneficiary. When a spouse chooses to treat an inherited annuity as their own, there are no immediate tax repercussions. It’s as if the spouse has owned the annuity from the beginning. It means, beyond required distributions at 70½ (if it was qualified), there is no distribution requirement.

Other inherited annuity tricks

There are other strategies available to the beneficiary that can save money, provide income, and increase investment options.

1035 exchange

A 1035 exchange, named after a provision in the Internal Revenue Code, allows you, under particular circumstances, to exchange one annuity for another without incurring taxes.

The fact of the matter is, the majority of annuities are overpriced. You are paying a premium for that guarantee, and there’s nothing wrong with that, but there are low-cost annuity options available. You can and should shop around. Be careful; lower cost doesn’t always mean better.

Roll a qualified annuity into an IRA

If you inherit a qualified annuity, you can roll it into an IRA. IRAs have lower fees and a better investment selection compared to annuities, but keep in mind you’re giving up the guarantee if you annuitize. It doesn’t matter if you’re a spouse, you can make it your own IRA, or a non-spouse, you can make it an inherited IRA.

The bait and switch

A younger spouse beneficiary who inherits a qualified annuity but needs funds before age 59½ should not make the annuity their own. They would avoid the 10% early distribution penalty that would apply if they did a spousal continuation before age 59½. Then when the beneficiary is 59½, they can then make the annuity their own.

Disclaiming the annuity

A beneficiary is allowed to refuse an annuity. Yes, you can refuse to inherit the annuity by disclaiming.  It just might even be in your best interest. When you disclaim an annuity, it then goes to the next beneficiary in line. No, unfortunately, you don’t get to dictate who gets the annuity. This decision should not be taken lightly. There are rules, repercussions, and traps. Read Thanks, But No Thanks! How To Refuse An Inheritance By Disclaiming to get the low down on how to disclaim an inheritance (annuity or otherwise).

Inherited annuity notes of warning

Just because I’ve laid out all of your options doesn’t mean they are all possible. Some annuity companies have gotten wise and now limit payout options. Even annuity owners can, in many cases, limit the distribution options for beneficiaries. Estate planning is required!

Qualified, non-qualified, lump, stretch, annuitize, 1035, it’ll make your head spin. There is no one solution for everyone. Your needs, tax situation, age, and comfort level all go into the equation on how best to handle an inherited annuity. Inherited annuities are complicated, proceed carefully and if you have any confusion or questions don’t hesitate to contact us or your CERTIFIED FINANCIAL PLANNER™  professional.

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