Inherited Annuities – Taxes, rules, and opportunities after inheritance

Inheriting an annuity can be a great windfall, but can also raise unexpected tax liabilities and administrative burdens to deal with. In this post we cover a few basics to be aware of when you inherit an annuity.

Inherited Annuity Tax Rates

First, know that there are 2 types on annuities from a tax perspective: Qualified, or non-qualified.

An inherited qualified annuity means that the money was saved in a IRA or 401(k), and there were no taxes paid upfront. When you take money out of an inherited qualified annuity, the full amount withdrawn will be counted as taxable income and taxed at your ordinary income tax rate, which can be quite high depending on your financial situation.

Non-qualified annuities were funded with savings that already had taxes paid. You will not owe taxes on the original cost basis (the total contributions made initially into the annuity), but you will still owe taxes on the growth of the investments however and that will still be taxed as income to you.

Annuity Death Benefit Payout Options

First, know that an annuity contract may not necessarily have a death benefit for the beneficiary. Especially if the original annuity owner had been receiving payments from the insurance company. Annuities are generally designed to provide income for the original annuity owner, and then cease payments once the original owner, and perhaps their spouse, have passed.

However, there are a few scenarios where an annuity may leave a benefit for the beneficiary inheriting the annuity:

1) The Annuity Has Not Yet Been Annuitized

This means that the initial owner of the annuity was not receiving regular payments from the annuity yet. If this is the case, the beneficiaries of the annuity will likely receive the full account value of the annuity.

The beneficiaries will have several options for how to receive their payout:

They may keep the money in the annuity, and have the assets moved to an inherited annuity account. In this case the assets may still remain invested and continue to grow, however there will be required withdrawal rules to be aware of. More on that below.

You may also be able to cash out and receive a lump sum payment from the inherited annuity. However, be sure you understand the tax impacts of this decision, or talk with a financial advisor, because you may be subject to significant income tax liability by making this election.

If you elect a lump-sum payout option on a qualified annuity, you will subject to income taxes on the entire value of the annuity.


2) There is a “Return of Premium” or “Period Certain” clause on the annuity

One option that annuity buyers have is a clause that guarantees a benefit for the annuity beneficiaries if the original owner does not receive a certain amount of money from the annuity over a period of time.

For example, consider a retiree that buys an immediate annuity for $100,000 that begins paying $500 per month in benefits. If this annuitant dies 12 months after purchasing the annuity, they only received $6,000. If they had elected a return of premium guarantee when they purchased the annuity, the beneficiary who is inherited this annuity may receive $94,000 as regular payments until the premium is paid back, or potentially a lump sum if the contract allows.

Note that not all annuities have this option, and it is likely an option that the original owner had to elect when buying the annuity.


3) There was a specific death benefit added to the annuity

Another feature that may exist for annuities is a guaranteed death benefit. If the original owner of the annuity elected this feature, the beneficiary will be eligible for a one time lump sum benefit.

How this is taxed will depend on the type of annuity and the value of the death benefit.


Distribution Rules – 5 Year Rule, 10 Year Rule, Lifetime Stretch Option

There are required distribution rules for inherited annuities. The specific rules you must follow depend on your relationship to the person that passed away, the type of annuity, and the wording in the annuity contract at time of purchase.

You will have a set time frame that you must withdrawal the assets from the annuity after the initial owners death. This may be 5 years, 10 years, or you may elect to receive lifetime annuity payments if you inherited a nonqualified annuity.

If you are a surviving spouse, or a minor child, you have more flexibility here. But if not, you must follow IRS rules on the withdrawal.

The new SECURE Act requires that all assets must be withdrawn within 10 years from qualified accounts. If you are a non-spouse beneficiary and inherited a qualified annuity, you very likely are on a 10-year clock in which you must withdraw all assets from the annuity.

Nonqualified annuities were not impacted by the SECURE Act, and may still follow a 5 year rule or allow the beneficiary to set up lifetime payments for themselves.

Because of the tax consequences of withdrawals from annuities, this means you need to carefully plan on the best way to withdraw from the account with the lowest amount in taxes paid.

Taking a large lump sum may push you into very high tax brackets and result in a larger portion of your inheritance going to pay the tax bill. We can help determine a strategy to withdraw the assets from your inherited IRA in the most tax-efficient manner.


1035 Exchange for Inherited Annuity

It is also important to know that annuities can be exchanged as well. This is known as a 1035 exchange and allows you to move the money from a qualified or non-qualified annuity into a different annuity with another insurance company. This can be a good option if the annuity contract you inherited has high fees, or is just not right for you.


Planning After The Inheritance of Annuity

Inheriting an annuity, along with other assets that likely come with it, can be lifechanging. Managing and investing an inheritance is incredibly important role that you will be forced into at the time of inheritance.

That can leave you with a lot of questions, and a lot of potential to make costly mistakes.

We are here to help.

Arnold and Mote Wealth Management is a fiduciary, fee-only financial planner. We’ll help you navigate this uncertainty and create a plan that maximizes your inheritance and other assets to create a retirement plan right for you.

Schedule a free introductory meeting today to see how we have helped hundreds of other clients just like you.

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