Inherited Annuity

Know your inherited annuity options to discover the tax savings

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 with 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 the required minimum withdrawals when you turn 73. 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, resulting 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. Once 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 of the owner to receive “regular income payments that have certain guarantees.” That, my friends, is called annuitization.

If annuity owners have 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 guaranteed 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. However, 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 annuity’s cash value. The beneficiary has several options for receiving the inherited annuity, depending on your relationship with 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 annuity’s entire balance must occur 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 rule, it doesn’t matter if you take all the proceeds in years one, two, five, or 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 an 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 goes to the next beneficiary in line; you don’t get to dictate who receives it. 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). The next beneficiary can determine their Inherited Annuity options if you disclaim it.

5. Annuitization: You may also annuitize the annuity. You select a single-life payout or a term-certain-only option shorter than your life expectancy, as 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 is my least favorite option because it’s too limiting.

But, if you’re afraid you’ll 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, 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 there is no distribution requirement beyond the required distributions at 73 (if it was qualified).

Stretch: This applies to non-qualified inherited annuities. 

Generally speaking, using the Spousal Continuance is more practical if you do not need the funds right away.

Other inherited annuity tricks

Different strategies are available to the beneficiary to 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 low-cost annuity options are available. You can and should shop around.

A word of caution. Make sure the current annuity has no surrender charges before considering 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 than annuities. But remember, 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.

Inherited annuity notes of warning

Just because I’ve laid out 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… these names will make your head spin. There is no one solution for everyone. Your needs, tax situation, age, and comfort level determine 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 your CERTIFIED FINANCIAL PLANNER™ professional or us.

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