What Is an Inherited Non Qualified Annuity?

An inherited non-qualified annuity can be a valuable financial asset, yet it often comes with a layer of complexity that can be daunting for many. Unlike qualified annuities, which are funded with pre-tax dollars and typically tied to retirement accounts like IRAs or 401(k)s, non-qualified annuities are purchased with after-tax dollars and are not subject to the same stringent IRS regulations. When you inherit a non-qualified annuity, you step into the shoes of the original owner, which means you must understand the specific rules and tax implications that accompany this type of inheritance.

A financial advisor can help you handle an inherited annuity, whether it’s qualified or not.

Understanding Annuities

Annuities are contracts between insurance companies and individuals that are often used in funding retirement. In return for a hefty payment from the individual, also known as the premium, the insurance company promises to make payments on a monthly or other regular basis.

The payments from an annuity can start immediately or at a set future date. They may last for a fixed number of years or the annuity buyer’s lifetime. Lifetime annuities can provide retirees with guaranteed income, no matter how long the retiree lives.

The terms of an annuity typically call for payments to end when the owner dies. However, provision can be made for a remaining balance to be passed to someone else. This lets the owner designate someone to inherit the remaining annuity payments.

Comparing Qualified and Non-Qualified Annuities

Qualified annuities are funded with pre-tax dollars, similar to contributions to IRAs or 401(k) plans. Any withdrawal from a qualified annuity is taxed at the owner’s rate in effect at the time of the withdrawal. The IRS limits the annual amount that can be put into a qualified annuity. And, like other tax-advantages retirement vehicles, owners of qualified annuities have to take required minimum distribution (RMD) withdrawals starting at age 70.5.

Non-qualified annuities are funded with money that has already been taxed. Instead of paying taxes on all withdrawals from the annuity, owners pay taxes only on the earnings. Since the money used to pay the principal or premium has already been taxed, it can be withdrawn later tax-free. The IRS doesn’t limit contributions, although the insurance company may place a cap on the size of the contribution, which is also called the premium.

Instead of paying taxes on all withdrawals from a non-qualified annuity, owners pay taxes only when withdrawing the earnings. Since the principal or premium has already been taxed, it can be withdrawn later tax-free. Also, non-qualified annuities don’t have to make RMDs.

Non-qualified annuities are similar to Roth IRAs. For instance, both types of retirement planning vehicles are funded with money that has already been taxed. Also, there are no RMDs on either Roth or non-qualified annuities. One difference is that when a Roth IRA holder withdraws from the account, any earnings are not taxed at the recipient’s regular rate. Earnings are taxed like normal income when withdrawn from a non-qualified annuity.

Taxing Inherited Non-Qualified Annuities

Someone who inherits a non-qualified annuity will have to pay taxes on withdrawals of the earnings but not the principal, just like the original owner would. This also applies to penalties on early withdrawals from the annuity.

If you withdraw money from an annuity before age 59.5, the IRS charges a 10% early withdrawal penalty. However, this penalty is only levied on early withdrawals of earnings on a non-qualified annuity, while a qualified annuity holder pays the 10% penalty on any withdrawals.

The IRS uses a formula to determine what part of a withdrawal is taxable earnings or tax-free principal. This is called the exclusion ratio. It’s based on the relationship between the initial premium and the total estimated payout of the annuity.

The exclusion ratio formula divides the initial premium by the total estimated payout. For instance, if you buy a $50,000 annuity that is expected to pay $100,000 over the life of the annuity, the exclusion ratio is $50,000 divided by $100,000 or 50%. This means that 50% of the monthly payout from the annuity would be taxed as earnings and 50% would be untaxed.

Other Types of Annuities

Annuities are financial products designed to provide a steady income stream, often used as part of retirement planning. Understanding the different types of annuities can help you make informed decisions about which option best suits your financial goals and needs. Below, we explore the main types of annuities available to consumers.

Deferred annuities: Deferred annuities accumulate funds over time, with payouts beginning at a future date, allowing for tax-deferred growth. They are beneficial for individuals who want to build their retirement savings over a longer period. This type of annuity is ideal for those planning for future income needs

Fixed annuities: Fixed annuities offer a guaranteed interest rate for a specified period, providing a predictable income stream. They are ideal for individuals seeking stability and low risk, as they are not affected by market fluctuations. This type of annuity is often chosen by those who prioritize security over potential high returns.

Variable annuities: Variable annuities allow you to invest in a selection of sub-accounts, similar to mutual funds, with returns that vary based on market performance. While they offer the potential for higher returns, they also come with increased risk. These annuities are suitable for those who are comfortable with market exposure and seeking growth opportunities.

Indexed annuities: Indexed annuities provide returns linked to a specific market index, such as the S&P 500, offering a balance between risk and reward. They typically include a guaranteed minimum return, protecting against significant losses. This type of annuity appeals to those who want to benefit from market gains while having some level of security.

Immediate annuities: Immediate annuities begin paying out almost immediately after a lump sum is invested, making them a good choice for those needing quick income. They are often used by retirees who want to convert their savings into a reliable income stream. This option eliminates the accumulation phase, focusing solely on payout.

Selecting the right type of annuity depends on individual financial goals, risk tolerance, and retirement plans. It’s essential to consider factors such as the desired level of income, the need for growth, and the willingness to accept risk. Consulting with a financial advisor can provide valuable insights and help tailor an annuity strategy that aligns with personal retirement objectives. By understanding the various types of annuities, individuals can make informed decisions that support their long-term financial well-being.

Bottom Line

Understanding what an inherited non-qualified annuity entails is crucial for anyone navigating the complexities of financial planning and inheritance. Unlike qualified annuities, which are funded with pre-tax dollars, non-qualified annuities are purchased with after-tax money, making their tax implications distinct. When you inherit a non-qualified annuity, you have several options for managing the payout, each with its tax consequences. Consulting with a financial advisor can provide valuable guidance tailored to your specific situation.

Tips on Annuities

Choosing an annuity requires carefully considering taxes, retirement needs and overall financial goals. That’s where a financial advisor can be valuable. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Don’t forget to integrate Social Security payments into your retirement plans. While they may not have a monumental effect on your finances in retirement, they can provide you with some extra cash at a time when you’ll need it most. To gain some insight into what you can expect from this government program, take a look at SmartAsset’s Social Security calculator.