Annuities can provide guaranteed income and be useful supplements to a traditional 401(k) plan or an individual retirement account. Some even have more than one beneficiary, since annuities can include a death benefit that allows payouts to continue for a family member. Since there are multiple options for annuity payouts, it’s important to know how they work and how taxes apply. We’ll cover the essential below, but consider engaging a financial advisor to maximize an inherited annuity’s benefits.
What Is the Difference Between Buying Annuities and Inheriting an Annuity?
Let’s start with the basics about annuities. Essentially, annuities are contracts life insurance companies issue to clients. When you purchase an annuity, you’re exchanging funds you have now for future income. You buy the annuity and the life insurance company, for a fee, agrees to make payments back to you on a pre-determined schedule. As with other investments, the money in the annuity can grow over time through interest accumulation and capital gains.
Often, annuities supplement retirement plans. However, they also can protect windfalls like lottery winnings or settlements from personal injury lawsuits. In these cases, the annuity protects a large asset and standardizes a payment schedule.
If the annuity has a death benefit provision or rider attached, the owner can name one or more individuals as inheritors of any money remaining. Death of the owner does not affect the payment schedule; if an owner dies 10 years after buying a 20-year annuity, the inheritor would receive payments for the remaining 10 years. In contrast, a lifetime annuity would continue paying out until the inheritor’s death.
Most inherited annuity recipients are surviving spouses, but they may be children or other family members. As such, the inherited annuity can be a building block in an estate plan or financial legacy.
How Inherited Annuity Payouts Work
An insurance company may offer you a few different options for receiving a payout. Each has its advantages, so comparison shopping is a sensible idea. Here are descriptions of some of the most common payout schemes.
1. Lump-sum payment. Let’s imagine your spouse purchased a $1 million-dollar annuity and $500,000 remains. You can elect to receive that amount all in one go and pay all taxes at the time of inheritance. You could then roll the payout into an IRA, or use it to fund another investment vehicle.
2. Stretch distribution payments. With a stretch distribution option, you take the remainder of the contract and stretch annuity payments out over the rest of your life. Your life expectancy sets the basis for your actual payment amount and schedule.
3. Five-year payments. This option essentially splits the difference between a lump-sum payout and stretch distribution payments. In this scenario, you have up to five years to withdraw the rest of the annuity contract. You can do this through a combination of smaller incremental payments and one final, lump-sum payment.
4. Spousal distribution payments. We might call this the ‘as-is’ option. In this case, the surviving spouse simply establishes themselves as the new annuity owner. The payout amount and frequency are the same as they were when deceased spouse established the annuity.
5. Annuitized payments. Think of this as the customized payment option. The annuity pays out over time, but you set the conditions to fit your preferences or needs. There is a caveat, in that with this option, once the schedule is chosen you can’t change it.
Tax Rules for Inheriting an Annuity
Like any other type of income, inherited annuities are taxable. The timing of the tax event depends on the payout structure and your status as a beneficiary.
For example, assume that you inherit an annuity from your spouse, and you choose to stick with the original payment structure, or the ‘as-is’ option. If payments are tax-deferred, any gains in interest, dividends or capital gains stay untouched until withdrawn. At the time of withdrawal, the established income tax rate applies. With lump-sum payments, the taxes apply all at once.
Qualified vs. Non-Qualified Annuities
There’s one more important question regarding inherited annuity taxes, which is whether the annuity is qualified or non-qualified. The difference is that a qualified annuity owner funded the account with pre-tax dollars, just like a traditional IRA or a 401(k). Once withdrawals begin, they’re automatically subject to ordinary income tax.
Non-qualified annuities, like Roth IRAs, use after-tax dollars, which means you will not pay any tax on the principal, or original investment amount. You still will be responsible for taxes on any earnings upon payment. Also, there are no caps on annual purchases for non-qualified annuities, although there are caps for qualified ones. So a high-earning spouse has the option of putting a great deal of money into a non-qualified annuity for the beneficiary’s sake.
Inheriting an annuity can provide you a lump-sum investment nest egg. Alternately, it can supplement Social Security payments, retirement funds and other income and provide an extra cushion over many years. Whatever your preference, consider the tax implications for withdrawals beforehand. Estimating your tax liability can help you decide whether to take payments immediately, incrementally or over the long-term.
Tips for Managing an Inheritance
- If you’re inheriting an annuity, treat it like any other inherited asset and consider where it fits into your larger financial plan. Specifically, you should think about whether it’s better to use it for short-term expenses or as extra retirement income. If you inherit an annuity from a spouse, be aware you have only 60 days to choose a lifetime payment structure.
- Professional advice can help you see all aspects of an inherited annuity and decide on the best course to take. Finding an advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Photo credit: ©iStock.com/Jirapong Manustrong, ©iStock.com/courtneyk, ©iStock.com/FatCamera