How to Avoid Paying Taxes on an Inherited Annuity

Inheriting an annuity can provide valuable financial support. However, it can also create unexpected tax obligations if you don’t understand the rules. Unlike many inherited assets that receive a step-up in basis, annuities face taxes when they’re distributed. This can lead leading to higher income taxes for beneficiaries. The good news? With careful planning and payout options, you can minimize the taxes and keep more of the annuity’s value.

A financial advisor can offer expert guidance for managing an inherited annuity or other assets.

Understanding Inherited Annuities

When someone purchases an annuity contract, they may have the option to name one or more beneficiaries. Those beneficiaries are then eligible to receive payments from the annuity if the original annuitant passes away. There are a few reasons why someone might choose to name an annuity beneficiary.

First, naming a beneficiary can help determine who receives any remaining death benefit under the contract. If the annuity names no beneficiary, what happens to the remaining value depends on the annuity’s terms and applicable law.

Second, naming beneficiaries to an annuity is one way to create a financial legacy for loved ones. If you have adult children, for example, you might add them as beneficiaries to a joint and survivor annuity. This grants them any remaining benefits once you and your spouse die. An annuity supplement other financial resources, such as life insurance or a trust, inside of an estate plan.

It’s important to note that some annuities can’t be inherited. If you purchase a single life or life-only annuity, for example, the annuity would only pay benefits to you during your lifetime. There would be no death benefit to pass on to a beneficiary.

How Inherited Annuities Are Taxed at Death

Understanding how the IRS taxes inherited annuities starts with knowing the difference between qualified and non-qualified annuities. You purchase a qualified annuity using pre-tax dollars through a tax-advantaged account, such as a 401(k) plan or an individual retirement account (IRA). Distributions from a qualified annuity become taxable income to the extent they represent money that still remains untaxed.

Early distributions from retirement accounts can ordinarily trigger a 10% additional tax, but distributions made to a beneficiary after the account owner’s death generally qualify for an exception. Qualified annuities must also follow the required minimum distribution (RMD) rules. A non-qualified annuity, on the other hand, uses after-tax dollars for its funding.

However, any growth or earnings on your initial investment become tax-deferred. In other words, you have to pay ordinary income tax on the earnings part of your distributions. Non-qualified annuities are not governed by the lifetime RMD rules that apply to traditional retirement accounts, although federal law can require an inherited non-qualified contract to be distributed according to specific post-death rules.

Tax Rules for Inherited Annuities

Your beneficiary status, and how you receive payouts, determine the taxes on an inherited annuity. If you’re the spouse of the original annuitant, then you can choose to continue receiving payments according to the annuity schedule. A surviving spouse may also have other continuation options depending on the contract. When the annuity remains eligible for tax deferral, taxes generally become due as taxable amounts are distributed.

It’s important to work with a professional if you’re trying to legally avoid taxes and set your finances up for long-term success. A financial advisor can help you understand what your options are for retirement and compare the tax effects of different inherited-annuity distributions within your overall investment portfolio.

Paying Taxes on an Inherited Annuity From a Deceased Parent or Non-Spouse

The rules work differently if you inherit an annuity and you are not the annuitant’s spouse. When you inherit a non-qualified annuity from a deceased parent or another person, you generally pay ordinary income tax on the portion representing previously untaxed earnings rather than automatically paying tax on the contract’s entire value. When you have to pay taxes depends on how you decide to receive distributions from the annuity.

If you inherit a qualified annuity, meaning one held inside an IRA or other retirement account, different rules apply. Under the SECURE Act, many non-spouse designated beneficiaries must fully distribute an inherited retirement account by Dec. 31 of the year containing the 10th anniversary of the original owner’s death. Different rules can apply to eligible designated beneficiaries, and some circumstances may require annual distributions during the 10-year period. ¹

How to Avoid Paying Taxes on an Inherited Annuity

You can’t avoid paying taxes when you inherit an annuity but you can defer payment on what you inherit. Here are some of the most common methods to manage taxable inherited-annuity income:

• Surviving spouse: Exercising your option to continue receiving payments as usual if you’re a surviving spouse maintains the tax-deferred status of an inherited annuity. Similarly, a non-spouse beneficiary may be able to spread distributions over time if federal rules and the contract permit an eligible payout schedule.
• 1035 exchange: Section 1035 can allow certain annuity-for-annuity exchanges without recognizing gain at the time of the exchange. Inherited annuities require additional care because the transaction must preserve the tax treatment required after the original owner’s death. Availability depends on the contract and the structure of the exchange, and an exchange defers taxable gain rather than erasing it. The main reason for considering a 1035 exchange of an inherited annuity would be to switch to an annuity with more favorable terms or benefits. ²
• Transfer of qualified inherited assets: An annuity held inside an IRA or another qualified retirement account follows the transfer and distribution rules for that type of retirement account. A non-spouse beneficiary generally cannot treat inherited retirement assets as their own IRA, although an eligible direct transfer to a properly titled inherited account may be possible. A surviving spouse can have additional options.

Assuming you’re able to transfer qualified inherited assets appropriately, you’d then be subject to inherited IRA tax rules.

Use our calculator to understand how tax brackets apply to your earnings.

How the Size of an Inherited Annuity Affects Your Tax Strategy

The payout option that makes the most financial sense depends on how the distributions interact with your tax liability. Two beneficiaries inheriting the same annuity can end up with very different tax bills. A lot depends on their income, filing status, and other assets.

The core issue remains the taxable portion of an inherited annuity distribution, which the IRS generally taxes as ordinary income. That means taxable distributions join your wages, Social Security, retirement account withdrawals and any other taxable income for the year. The more you take in a single year, the more income you may have exposed to higher marginal tax rates.

For a beneficiary with modest income, an available multiyear payout can spread taxable income across several tax years. Whether that reduces the beneficiary’s total federal tax depends on the taxable portion of the annuity, other income received in each year and the tax rates that apply.

For a beneficiary already earning a high income, the calculus shifts. Adding taxable annuity income to an already high-income year can push you into a higher marginal bracket. You should compare taking a lump sum payout to scheduled distributions to see which works best. Just understand neither option automatically produces the lower lifetime tax bill.

Lump Sum Payouts

A lump sum makes the most financial sense in a narrow set of circumstances. If the annuity is small relative to the beneficiary’s overall financial picture, if the beneficiary is in a low income year due to job loss or retirement, or if the annuity has unfavorable terms that make ongoing payments unattractive, taking everything at once and paying the tax may be cleaner than managing distributions over years. The key is modeling what the lump sum actually costs in the year of receipt before making that decision, not after.

The key is modeling what the lump sum actually costs in the year of receipt before making that decision, not after.

When the five-year rule applies, the beneficiary generally has until the end of the required five-year period to distribute the remaining interest. The contract can impose additional restrictions, so a beneficiary who expects income to change during that period can compare the available timing choices before requesting a distribution.

Common Mistakes Beneficiaries Make With Inherited Annuities

Most costly mistakes with inherited annuities happen in the first few weeks. Often beneficiaries don’t take the time to understand what they actually inherited or how to manage it.

Taking a lump sum without first calculating its taxable portion can accelerate income into a single tax year. For a contract with substantial untaxed earnings, comparing distribution options can reveal how each choice would affect taxable income.

Another mistake is assuming every insurer uses the same election deadline. Deadlines and beneficiary procedures can vary by contract so beneficiaries should review the contract or contact the insurer promptly. They need to identify their available choices and any dates that apply.

Assuming an inherited annuity works like an inherited IRA leads to similar problems. The rules differ in meaningful ways depending on whether you have a qualified or nonqualified annuity. A non-qualified annuity follows the post-death rules applicable to annuity contracts. But a qualified annuity held in an IRA or retirement plan must satisfy the distribution rules for that retirement account.

Non-Qualified Annuities

For qualified annuities held inside an IRA or other retirement account, the SECURE Act of 2019 eliminated the stretch for most non-spouse beneficiaries, replacing it with the same 10-year depletion rule that governs inherited IRAs. Eligible designated beneficiaries can qualify for different distribution treatment. In fact, some beneficiaries subject to the 10-year rule must also take annual distributions during that period. ³

Failing to check whether the annuity is qualified or non-qualified before making any decisions is another common mistake. The tax treatment of each is fundamentally different, and the strategies available to reduce the tax burden vary accordingly. A beneficiary who does not know which type they inherited cannot evaluate their options accurately.

Doing nothing can also narrow the choices available if a contract or federal rule imposes a deadline. Before making an election, beneficiaries can confirm whether the annuity is qualified or non-qualified. They can also identify the remaining tax basis, review the death benefit, and obtain the insurer’s available distribution options.

How to Calculate the Taxable Amount Before Taking a Payout

Before choosing how to receive an inherited annuity, it helps to separate the contract’s total value from the amount that may actually be taxable. For a non-qualified annuity, the original owner generally funded the contract with after-tax money. The untaxed growth above that remaining investment in the contract is generally the portion that creates ordinary income for the beneficiary. Annuities generally do not receive the same basis adjustment at death that applies to many other inherited assets.

Assume a parent paid $90,000 into a deferred non-qualified annuity and had not previously recovered any of that investment. The contract is worth $125,000 when the parent dies. Under those assumptions, the contract contains $35,000 of previously untaxed growth:

• $125,000 contract value – $90,000 investment in the contract = $35,000 of gain

That does not mean every payout method produces the same amount of taxable income in the same year. A lump-sum distribution can cause the taxable gain to be recognized sooner, while a qualifying annuity payout can divide taxable and nontaxable amounts according to the rules that apply to the payment stream. The insurer can provide information about the contract’s investment, value and available beneficiary elections before a payout is requested.

The calculation can look very different for a qualified annuity. If the contract funding came from pretax retirement money, the IRS may tax most or all of a beneficiary’s distributions. If after-tax contributions are present, part of the payments may represent a recovery of basis. Identifying which type of annuity you inherited is therefore an important first step before comparing tax strategies.

Bottom Line

Inheriting an annuity can be a financial boon, but it often comes with tax implications that require careful consideration. To minimize the tax burden, it’s crucial to understand the options available, as discussed above. By carefully evaluating these strategies, beneficiaries can make informed decisions that align with their financial goals while effectively managing the tax responsibilities associated with an inherited annuity.

Tips on Inheritance

• Do you have questions about your inheritance? A financial advisor can help with this. 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.
• If you’re considering purchasing an annuity, learn how different annuity options work. Ask if you can name a beneficiary and how payments will continue if you’re buying a joint and survivor annuity. Also, research the various costs involved in purchasing and owning an annuity.

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