Inherited Annuity

Know your inherited annuity options to discover the tax savings

*Please note, the following post has been updated with the most recent SECURE Act of 2019

It’s hard to wrap your head around annuities in the best of times. The task becomes even more challenging when you inherit one after the death of a loved one. 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, but distributions are taxed as income. If you withdraw funds before age 59½, there is a 10% penalty. Also, you must begin required minimum withdrawals when you turn 72. Sound familiar? Yes, 401(k)s, 403(b)s, and IRAs have the same rules.

Non-Qualified Annuity: Contributions are after-tax, but growth/earnings are tax-deferred and result in a mix of taxable (earnings/growth) and nontaxable (contributions) distributions. Like the qualified annuity, there is a restriction on taking funds out before age 59½, again subject to a 10% penalty. However, there are no requirements to begin to withdraw funds after age 72. Please note, the first dollars out would be considered your gain and taxed at ordinary income tax rates. AOnce the gains have been depleted, the distributions are considered a tax-free return of principal.

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 a “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).

No named beneficiary requirement

When an annuity has no designated beneficiary, it is left the estate. In that situation, there is only one option.

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 it’s all in years one, two, five, or spread out over each of the five years.

Non-spouse options

1. 10-year rule: The distributions must be made to designated beneficiaries within ten years from the date of the owner’s death. Again, like the five-year rules, it doesn’t matter if you take all the proceeds in years one, two, five, eight, or spread them out over each of the ten years.

2. Non-spouse Inherited IRA Annuity Stretch Exceptions:  The SECURE Act of 2019 eliminated the stretch inherited IRA annuity provision. However, there are exceptions if you’re an eligible designated beneficiary (EDB): 

  • Minor children up until they reach their majority – but not grandchildren,
  • Disabled or chronically ill individuals,
  • Individuals who are not more than ten years younger than the IRA owner. 

The beneficiary, if and EDB, can still use the stretch annuity provision and stretch the distributions out over their own lives. 

3. Inherited non-qualified annuity stretch: The stretch option for non-qualified annuities is still in place. The beneficiary can stretch the distributions out over their own lives. 

4. Disclaiming the Annuity: A beneficiary is allowed to refuse an annuity. When you disclaim an annuity, it then goes to the next beneficiary in line; you don’t get to dictate who receives the annuity. There are rules, repercussions, and traps. Read Thanks, But No Thanks! How To Refuse An Inheritance By Disclaiming to learn more about how to disclaim an inheritance (annuity or otherwise). If you disclaim it, the next beneficiary in line can determine their Inherited Annuity options.

5. 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 non-qualified 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.

But, if you’re afraid you’re going to run out of money, or if you’ll feel better knowing you have a guaranteed monthly payment, annuitizing may be 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 72 (if it was qualified), there is no distribution requirement.

Stretch: This applies to all inherited annuities, qualified since spouses are one of the EDB’s, and non-qualified because everyone can stretch the non-qualified. 

Generally speaking, it’s more practical just to use the Spousal Continuance, if you do not need the funds right away.

Other inherited annuity tricks

There are different 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.

A word of caution. Make sure the current annuity does not have any surrender charges before you consider a 1035 exchange.

Roll a qualified annuity into an IRA

If you inherit a qualified annuity, you can roll it into an inherited IRA. IRAs have lower fees and usually have 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 an annuity but needs funds before age 59½ should not make the annuity their own. If they took the Spousal Continuation option and received a distribution before age 59 1/2, they would be subject to the 10% early distribution penalty. The best course of action would be to take the Stretch Provision until they have reached 59½. Then switch the Spousal Continuation after 59½.

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, 5-year, 10-year, 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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