Inherited Annuity: What Are My Options?

Are inherited annuities taxable? I will be receiving an inherited annuity. What’s the best way to handle this large sum of money? This guide will provide you with a few options for both qualified and nonqualified annuity beneficiaries on how you can efficiently inherit the death benefit.

What Happens When I Inherit An Annuity?

An annuity is a contract in which you and an insurance company agree to pay specific amounts of money at set intervals. The main difference between types of annuities pertains to when payments are received and how the money collected grows.

Immediate annuities allow payments to begin immediately, while deferred annuities defer payments until later.

Your annuity contract likely has a standard death benefit, which gives a beneficiary the right to either receive the whole annuity in one lump sum or get periodic payments from the annuity after you die.

Though an annuity shares some qualities with a life insurance policy, there are significant distinctions between the two. Payouts upon death and tax liabilities primarily differ between an annuity and life insurance policy.

Non-Qualified Annuity Inherited Death Benefit Payout Options

By design, the annuity death benefit provides money to help your loved ones after you’re gone. For example, upon your passing, you could financially support your spouse through their golden years or gift a more substantial inheritance to one of your children. Those named as beneficiaries can choose to receive the lump sum all at once or rather in manageable increments over time.

What Is Considered As A Non-Qualified Annuity

A non-qualified annuity is a retirement savings product you fund with after-tax dollars. The money in the account grows without being taxed, so you don’t have to pay taxes on it until you take distributions (withdrawals) from the account. When you do start taking withdrawals, you only have to pay taxes on your earnings; since you already paid taxes on your contributions, those are not taxed again.

Lump-Sum Payment

If you elect to receive a lump-sum payment from your non-qualified annuity, the beneficiary will get the entire balance of the annuity. Be aware that there are tax implications, as income taxes will apply to any interest earned on the original deposit amount.

Periodic Payments

There are two types of annuities: the single-life payout and the term-certain payout.

• The single-life payout gives you money every month until you die. If there is still money left after you die, it goes back to the insurance company.
• With the term-certain payout, you get money every month for a set number of years. Annuity payments are distributed for a pre-determined fixed length of time. At the end of the term, the annuitant will no longer receive any more payments.

Five-Year Rule

The Five-Year Rule dictates that the non-spousal beneficiary of a non-qualified annuity must withdraw the entire balance within five years of the owner’s death. This rule provides the beneficiary with several options about when to receive the death benefit proceeds. You have three options:

• take all the money out immediately after the death of the owner,
• take payments periodically over the five-year period, or
• wait until the fifth year to take all annuity proceeds at once.

The IRS taxes annuity income based on the gains that are distributed from the contract. The five-year rule is the only guideline trusts, charities, or estates must follow if they are beneficiaries of a non-qualified deferred annuity.

Spousal Beneficiaries

If the annuity’s original owner dies before payments start, and the spouse is a joint owner or the only beneficiary, they can continue owning the contract through a provision called Spousal Continuation.

After a change in ownership, the contract will still be honored as if the surviving spouse owned it from the beginning. This means that its valuable tax-deferred status is untouched, meaning that the beneficiary won’t have to pay any taxes immediately, and they will begin receiving payments at whatever interval was originally agreed upon.

Non-Qualified Inherited Annuity Taxes

The general rule for non-qualified annuities is last-in, first-out. Therefore, the IRS sees the non-taxed amount as being used up first when you make a withdrawal. When you receive an annuity through inheritance, you are given what is called the “owner’s basis,” which means that the already taxed money in the account belongs to you.

Qualified Annuity Inherited Death Benefit Payout Options

What Is Considered As A Qualified Annuity

A qualified annuity is a retirement savings plan that uses pre-tax dollars. An IRA annuity is one example of a qualified annuity.

Lump-Sum Payment

The beneficiary will get the entire annuity if you elect to receive a lump-sum payment from your qualified annuity. Be aware that there are tax implications, as income taxes will apply to the entire annuity’s balance.

10-Year Rule

The SECURE Act, which took effect on January 1st, 2020, stated that any non-spousal beneficiary who inherits an IRA annuity generally has 10 years to withdraw all the money from the account.

If you don’t comply, anywhere from 50% of the money in your account will be subject to a penalty. Exceptions include:

• spouses
• children who are minors,
• as well as disabled or chronically ill beneficiaries,
• and those within 10 years of the age of the original account holder.

Spousal Beneficiaries

If the annuity’s original owner dies before payments start, and the spouse is a joint owner or the only beneficiary, they can continue owning the contract through a provision called Spousal Continuation.

Qualified Inherited Annuity Taxes

The general rule for qualified annuities is all withdrawals are considered taxable income. The Roth IRA is the exception.

What is the best thing to do with an inherited annuity?

The best thing for a surviving spouse is to keep the annuity intact through spousal continuance and name new beneficiaries. The annuity won’t be taxed immediately, placing the widow in a higher tax bracket. For non-spousal beneficiaries, consider rolling the inheritance into another deferred annuity with a premium bonus to offset any taxes owed.

If these options don’t work, it may make sense to cash out the annuity and invest the proceeds in a way that makes more sense for their financial needs and goals.

Some factors to consider when deciding what to do with an inherited annuity are:

• The size of the inheritance
• The age of the beneficiary
• The tax implications of cashing out or keeping the annuity
• The fees associated with cashing out or keeping the annuity
• The financial needs and goals of the beneficiary

How much tax do you pay on an inherited annuity?

The tax rate on an inherited annuity depends on the type of annuity and the beneficiary’s relationship to the person who purchased the annuity.

If the annuity is a qualified annuity, the entire payout is taxed as ordinary income in the year it is received.

If the annuity is a non-qualified annuity, the taxable portion is the difference between the purchase price of the annuity and the total amount of payments received. This portion is taxed as ordinary income in the year it is received.

The beneficiary’s tax rate also depends on their relationship with the person who purchased the annuity.

Qualified Vs. Nonqualified Death Benefits

• Qualified Inherited Annuities = All death benefits will be subject to taxes.
• Nonqualified Inherited Annuities = Only the interest earned will be subject to taxes.

Nonspousal Inherited Annuity

If you’re a non-spousal beneficiary, you may have the option to transfer the death benefit amount into a new inherited annuity. This method will provide a way to spread your tax liability while allowing the inheritance to continue growing.

The Benefits

Continuing the annuity’s growth

Transferring the death benefit into an inherited annuity, your assets may continue to grow, which can significantly boost your inheritance over time.

Spread income tax impact over time

Collecting the death benefit as a lump sum payment could leave you with a significant tax burden. However, utilizing an inherited annuity, your money will not be taxed until you make a withdrawal.

Designating your beneficiaries

With a new inherited annuity contract, you will be able to name a new beneficiary in case of your premature death.

Spousal Inherited Annuities

The same options apply to spousal inherited annuities, but with one additional option, spousal continuance. Spousal continuance will allow the surviving spouse to continue the deceased’s annuity and avoid paying taxes at death. Any withdrawals from now on will be subject to ordinary income taxes.

Things To Know

• In many cases, the IRS requires the first payment from an inherited IRA to be made by December 31 of the calendar year following the owner’s death. Likewise, the first payment from an inherited non-qualified annuity must be made by the first anniversary of the owner’s death.
• If the death benefit is paid directly to you, a new inherited annuity will no longer be an option. If you decide to open an inherited annuity, the death benefit will need to be transferred to another insurance company that will accept inherited annuity funds.
• The IRS requires you to withdraw a minimum amount each year in many cases. Required Minimum Distributions (RMD) for an inherited IRA or a 72(s) payment for an inherited non-qualified contract. In some cases, a final distribution must be made from an inherited IRA annuity after ten years.

Can I roll over an inherited annuity?

In general, you cannot roll over an inherited annuity. However, there are a few exceptions.

If the deceased were your spouse, you might be able to roll over the annuity into your account. This is called a spousal rollover.

If the deceased was younger than age 59½ at the time of death, you might be able to postpone withdrawals from the annuity for up to five years. This is called a 5-year rule rollover.

In both cases, you will have to pay taxes on the money you receive from the annuity.

Who pays taxes on annuity at death?

The beneficiary of an annuity pays taxes on money received from the annuity. The tax rate depends on the type of annuity and the beneficiary’s relationship to the person who purchased the annuity.

If the annuity is an immediate annuity, the entire payout is taxed as ordinary income in the year it is received.

If the annuity is a deferred annuity, the taxable portion is the difference between the purchase price of the annuity and the total amount of payments received. This portion is taxed as ordinary income in the year it is received.

The beneficiary’s tax rate also depends on their relationship with the person who purchased the annuity. For example, if the beneficiary is a close relative, such as a spouse or child, they may be eligible for a lower tax rate.

Consider Life Insurance

If you want to leave money to your beneficiaries, life insurance might be better. In some cases, you don’t need to take a medical examination. Instead, compare instant life insurance quotes to determine if affordable coverage is available. Coverage starts at $9.37 per month.

Next Steps

You now know the difference between a qualified and nonqualified annuity and how to inherit an annuity account. These are important factors to consider when trying to decide what is best for you. Our team can help guide you through this complex process so that you make the decisions that are in your best interest. Please reach out for a quote.

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• What is Spousal Continuance?
• How to Retire on $200,000 Inheritance