If you are on the receiving end of an inherited annuity, it could turn out to be a double-edged sword. While an inherited annuity can provide an unexpected windfall, the tax implications of withdrawing money from it could be costly. Although you can’t completely avoid taxes on annuity payouts, by understanding how an annuity is structured and how you choose to receive the benefits, you can minimize the tax burden while taking greater advantage of the tax deferral provided by an annuity.
What is an Inherited Annuity?
An annuity is a contract between an individual and a life insurance company wherein, for a lump sum of money, the insurer guarantees a specific amount of fixed, periodic payments over the annuitant’s lifetime or for a certain period of time (i.e., ten years). Annuity payments consist of a return of principal—the money the annuitant pays into the contract—and interest earned inside the contract. The interest portion is taxed as ordinary income, while the principal amount is not taxed. For annuities paying out over a more extended period or life expectancy, the principal portion is smaller, resulting in fewer taxes on the monthly payments.
When someone purchases an annuity, they have the option to name one or more beneficiaries who become eligible to receive the payments if the annuitant dies. For a married couple, the annuity contract may be structured as joint and survivor so that, if one spouse dies, the survivor will continue to receive guaranteed payments and enjoy the same tax deferral.
If a beneficiary is named, such as the couple’s children, they become the recipient of an inherited annuity. As beneficiaries, they can choose from four distribution options that produce four different tax consequences.
Distribution Options from an Inherited Annuity
Beneficiaries have multiple options to consider when choosing how to receive money from an inherited annuity. The best choice for any individual should be based on their current circumstances, tax situation, and financial objectives.
Lump-sum: The money from an inherited annuity can be paid out as a single lump sum, which becomes taxable in the year it is received.
Five-year rule: Payments can be spread out over five years, also spreading out the tax burden. The drawback to this option is that the earnings in the contract are distributed first, which are taxed as ordinary income. The tax-free principal is not paid out until after the earnings are paid out.
Annuitization: The beneficiary can request that the proceeds be annuitized—turning the money into a stream of income for a lifetime or a set period of time. The downside to annuitization is that it is irrevocable, meaning you can’t have access to the money except through the monthly payments. The upside is the payments are only partially taxed on the interest portion, which means you can defer taxes well into the future.
Nonqualified stretch: Also referred to as the Life Expectancy or One-year Rule, the nonqualified stretch option uses the beneficiaries remaining life expectancy to calculate an annual required minimum distribution. Nonqualified means that the inherited annuity was not originated inside a qualified retirement plan, such as an IRA. The stretch option offers more flexibility in how and when you can access money from an inherited annuity while maximizing its tax deferral.
Beneficiaries determine their initial life expectancy using the IRS Single Life Table. Each year, one year is subtracted from the initial life expectancy factor to determine the required minimum distribution for that year. For example, if the initial life expectancy factor is 30 years, the amount of capital available for distribution is divided by 30 to determine the minimum payout for that year. The following year, the remaining amount of money is divided by 29, and so on. If there are multiple beneficiaries, each one can use their own life expectancy to calculate minimum distributions.
With the stretch option, beneficiaries are not limited to taking the minimum distribution. They can take as much as they want up to the entire remaining capital. Also, they are required to take a distribution even if they don’t want to.
Beneficiaries can name a successor beneficiary who can finish taking the required minimum distributions if the beneficiary dies. However, the successor beneficiary must base minimum distribution amounts on the life expectancy of the first beneficiary.
Of the four options, the annuitization or nonqualified stretch options are best if you want to spread your tax burden over a more extended period of time. However, if you are most concerned about getting more money in your hands more quickly, the lump sum or five-year rule options are the best options, keeping in mind you will incur a larger and more immediate tax liability.
1035 Exchange Option
If you don’t have an immediate need for the cash from an inherited annuity, you could choose to roll it into another annuity you control. Through a 1035 exchange, you can direct the life insurer to transfer the cash from your inherited annuity into a new annuity you establish. That way, you continue to defer taxes until you access the funds, either through withdrawals or annuitization. If your inherited annuity is nonqualified (established outside a qualified retirement plan), it would have to be exchanged for another nonqualified annuity. If the inherited annuity was originally established inside an IRA, you could exchange it for a qualified annuity inside your own IRA.
The Bottom Line
Inheriting an annuity can be a financial boon. But, without thoughtful consideration for tax implications, it could be a bust. While it’s not possible to completely avoid taxes on an inherited annuity, there are several ways to minimize current taxes while maximizing tax deferral and increasing the long-term value of the annuity. Annuities can be somewhat complex instruments, and their taxation is even more difficult to understand. It’s essential to do your research and consult with a financial advisor before making any decisions. You can start with our free guide, Should You Invest in Annuities—8 Questions You Should Ask Before You Decide, and then follow up with a no-obligation consultation with a Dechtman Wealth Management advisor.
Dechtman Wealth Management, LLC and its representatives do not provide tax or legal advice.
