Can I Avoid Paying Taxes on an Inherited Annuity?

Understanding your options is key to managing taxes on inherited annuities.

• Inherited annuities come with inevitable tax implications.
• Distribution options like lump-sum, five-year rule, or annuitization affect your tax burden.
• The 1035 exchange can help defer taxes by transferring the annuity to a new one.
• Consulting a financial advisor ensures you make informed decisions that may help to minimize taxes and maximize value.

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.

Let’s be clear: if you’re wondering, “Can I avoid paying taxes on an inherited annuity?” the technical answer is that you can’t. There will always be some inherited annuity taxes. However, you may be able to significantly reduce your tax burden in many situations.

Learning about your options related to taxes and inherited annuities can help you keep more of the funds from that asset. Let’s take a closer look at how annuities are structured, as well as your options for receiving the benefits of an inherited annuity.

What is an Inherited Annuity?

At its core, an annuity is a contract between an individual and a life insurance company.

In return for a lump sum of money provided by the individual (or a series of payments), the insurer guarantees a specific amount of fixed, periodic payments. These payments may extend over the annuitant’s lifetime or last for a specific period of time (i.e., ten years) defined in the contract.

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.

People decide to buy annuities for a few key reasons. The guaranteed payments are the primary motivation for more people.

The tax benefits we just reviewed are also important. The ability to designate a beneficiary and have the payments continue in the event of the purchaser’s death is crucial as well.

When someone purchases an annuity, they have the option to name one or more beneficiaries. These named individuals become eligible to receive the payments if the annuitant — the person who took out the annuity — dies.

For a married couple, the annuity contract may be structured as joint and survivor. That means 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 child, they become the recipient of an inherited annuity. As the beneficiary, 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 Distribution

The money from an inherited annuity can be paid out as a single lump sum, which becomes taxable in the year it is received. If the annuity was held in a retirement account, the entire amount is taxable at your marginal income tax rate. If the annuity was held in a non-qualified account (non retirement account), then only the earnings are taxable at your marginal income tax rate. This can lead to a significant tax burden, although it also offers flexibility and immediate access to the after-tax funds from the annuity.

Five-Year Rule

Payments from an annuity 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 and are taxed as ordinary income.

The tax-free principal is not paid out until after the earnings are paid out. That means the inherited annuity taxes will drop off once the earnings are exhausted and the tax-free principal becomes the source of the payments.

Annuitization

The beneficiary can request that the proceeds be annuitized. This option turns the money into a stream of income, either for a lifetime or a set period of time. It’s a consistent and dependable source of funds, which can be attractive in many different situations.¹

The downside to annuitization is that it is irrevocable. That means you can’t have access to the money except through monthly payments. That’s true even if your financial circumstances change and the total amount of funds is wanted or needed.

The upside is the payments are only partially taxed on the interest portion, which means you can defer taxes well into the future. Depending on your tax position and overall financial situation, this option may help some of the taxes on an inherited annuity.

Nonqualified Stretch

Also referred to as the Life Expectancy or One-Year Rule, the nonqualified stretch option uses the beneficiary’s remaining life expectancy to calculate an annual required minimum distribution.

Nonqualified means that the inherited annuity did not originate 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 helping to maximize 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.

Which Annuity Distribution Option is Right for Me?

Choosing your annuity distribution option can have a major impact on your overall tax burden. Consulting with a fiduciary financial advisor — a professional bound to act in your best interests — can help you better understand how to move forward.

Here is a general and brief review of how these distribution options can influence your finances and how the inherited annuity taxes apply in each situation.

Of the four options, the annuitization and nonqualified stretch options may be appropriate if you want to spread your tax burden over a more extended period of time. This option may help the most in terms of reducing the initial inherited annuity taxes, although some amount of tax will always have to be paid.

If you are most concerned about getting more money in your hands more quickly, the lump sum or five-year rule options may be appropriate. Keep in mind that you will incur a larger and more immediate tax liability if you select the lump-sum or five-year rule distribution options.

A financial professional can help you evaluate your options and determine the best strategy for you.

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. As Investopedia explains, a 1035 exchange allows for the tax-free transfer of annuity contract (among other assets) for another asset of a like kind.

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 on Inherited Annuity Taxes

Inheriting an annuity can be a financial boon.

While it’s not possible to completely avoid taxes on an inherited annuity, there are several ways that may help to minimize current taxes and maximize tax deferral. This may increase the long-term value of the annuity.

Annuities can be somewhat complex instruments, and their taxation is even more difficult to understand. We believe It’s essential to do your research and consult with a financial advisor before making any decisions.

Discuss Your Inherited Annuity with a Financial Advisor

1. The guarantees and benefits provided are subject to the claims paying ability of the issuing insurance company. ↩︎