How To Pass Money To Heirs Tax-Free And Avoid Paying Taxes on An Inheritance.

Shawn Plummer

CEO, The Annuity Expert

Want to learn the best ways to leave money to heirs, tax-free? When someone dies, their estate is typically divided among their heirs. If you are one of the lucky people who inherit money or property, you may be wondering if you have to pay taxes on it. This guide will provide tax strategies to minimize or avoid paying taxes on an inherited annuity, 401k, and IRA. These tax strategies are perfect for:

This guide will answer the following questions:

  • Do you pay taxes on an inheritance?
  • Do beneficiaries pay taxes on estate distributions?
  • How do I avoid paying taxes on an inherited IRA?
  • How to pass money to heirs tax-free?
  • How can I avoid paying taxes on annuities?

Do You Pay Taxes On An Inheritance?

Are death benefits taxable? Yes, beneficiaries will pay taxes on death with most qualified retirement plans such as an IRA or 401(k). The entire amount left to heirs is subject to taxes (except for a Roth IRA). Any retirement savings funded with after-taxed money are subject to taxes, but only the interest earned is taxable.

How To Pass Money To Heirs Tax-Free

To avoid taxes on inheritance for your beneficiaries, utilize a deferred annuity or a life insurance policy. Annuities offer enhanced death benefits to allow beneficiaries to offset taxes or spread the tax burden over time. Life insurance will also allow the conversion of a tax-deferred status to tax-free status while a policy owner is alive.

Annuity Example

The ClassicMark Fixed Index Annuity offers an optional enhanced death benefit called the Heritage Maximizer that will pay a 30% bonus on the annuity’s total value when the owner dies (see rules and guidelines). This 30% bonus will pay most if not all Federal and State taxes, allowing beneficiaries to collect the proceeds in a lump sum without losing their inheritance. This annuity is perfect for 401(k) and IRA savings currently in a tax-deferred status. The enhanced death benefit is also a solid alternative to retirees who can not purchase life insurance coverage due to pre-existing medical conditions because no medical underwriting is required.

For the insured wanting to leave money to heirs.

Here are a few tips if you’re researching ways to pro-actively want to leave your beneficiaries’ inheritance and reduce their tax burden. These strategies apply to qualified retirement plans such as a 401k or IRA and annuity accounts.

Note* If you are healthy, purchase life insurance first, then consider these tax strategies.

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Annuities with Enhanced Death Benefits

Generally, annuities avoid probate, which automatically is not included in the deceased’s estate (if set up correctly), but how to avoid paying ordinary income taxes? Some annuities offer a life insurance alternative called Enhanced Death Benefits. These benefits are designed to maximize a death benefit without the medical underwriting required with applying for life insurance.

By utilizing these enhanced death benefits, your heirs would either

  • spread the tax burden over time,
  • pay fewer taxes overall, or
  • completely cover their tax bill.

Life Insurance-Annuity Hybrid Plans

Generally, life insurance provides tax-free proceeds to beneficiaries but accepts only after-tax money. What about qualified retirement plans such as an IRA or 401(k)? This is where life insurance-annuity-hybrid plans come into play.

The life insurance annuity plan consists of two contracts, a temporary Single Premium Immediate Annuity (SPIA) and Single-Premium Life Insurance Policy.

Converting Annuities, 401k, and IRA to Life Insurance

The payments from the SPIA will go directly to the life insurance policy. This process lets the insured spread the taxable income in the funds used to purchase the SPIA over a 5,7, or 10 year payment period. The result is leaving a tax-free death benefit for your beneficiaries.

These hybrid plans also can fulfill RMDs for your IRA or 401(k) as well.

The life insurance coverage is guaranteed on Day 1 and will not lapse as long as the hybrid plan is not canceled.

Some life insurance annuity plans will offer both the tax-free life insurance proceeds and the remaining payouts if the insured dies before the payout duration ends.

Examples:

The Application Process

  1. Request a quote.
  2. Submit an application and health questionnaire.
  3. Conduct a 20-minute phone interview with a medical underwriting team.
  4. Wait up to 48 hours for approval. Typically, the approval rate is high; the decline rate is low.
  5. If approved for life insurance coverage, transfer the funds.
  6. Each year you’ll receive a 1099 form to report the SPIA payment to the IRS.

How To Avoid Taxes On An Inherited Annuity

The Surviving Spouse

If a surviving spouse recently inherited an annuity, they can either pay taxes on all of the funds now, spread the tax payment over time, or exercise the spousal continuation provision. Spousal continuation is the tax strategy to avoid paying taxes now.

Non-Spousal Beneficiaries

If a non-spousal beneficiary inherits money, an annuity, or a qualified retirement plan without the benefits mentioned, they can utilize a bonus annuity to help offset the tax burden.

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What Is The Tax Rate On An Inherited Annuity?

Typically, inherited annuities are taxed at the ordinary income tax rates of the beneficiary.

Conclusion

To avoid taxes on inheritance, you can use a deferred annuity or a life insurance policy. Annuities offer enhanced death benefits that allow beneficiaries to offset taxes or spread the tax burden over time. Life insurance will also allow the conversion of a tax-deferred status to tax-free status while a policy owner is alive. Request a quote and let us help you find the best way to protect your loved ones from excessive taxation.

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Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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