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

An annuity is a contract with an insurance company that can be used to accumulate money and, in some cases, create a stream of income later in life. You typically make either a lump-sum payment or a series of contributions, and the insurer provides benefits based on the terms of the contract.

Money inside an annuity generally grows tax-deferred, meaning you typically do not owe income tax on earnings until you withdraw them. Depending on the type of annuity, growth may be based on a fixed interest rate, the performance of underlying investments or changes in a market index.

Annuities can provide income in several ways. Owners may take withdrawals as needed, receive scheduled payments or annuitize the contract to create a stream of payments for a specified period or potentially for life, depending on the contract. Annuity owners can typically name one or more beneficiaries to receive the contract’s remaining value after death. The beneficiary’s relationship to the owner, the contract terms and the distribution method chosen can all affect how quickly the money must be distributed and how the taxable portion is treated.

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.

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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

An inherited non-qualified annuity can provide a meaningful financial benefit, but it also comes with tax and distribution rules that can affect how much you ultimately keep. Because the original owner funded the annuity with after-tax dollars, beneficiaries generally owe income tax only on the earnings portion, though the timing and amount of that tax can depend on how the money is withdrawn. Before choosing a payout option, it can help to review the contract, understand the tax consequences and consider how the inheritance fits into your broader financial plan.

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.