Inheriting an annuity can provide an unexpected financial windfall, but there are certain tax implications to consider. Whether you’ll owe taxes, how much and when you’re required to pay them depends on how the annuity is structured and how you choose to receive benefits. However, there are strategies you can use to minimize your tax hit. If you’re looking for expert guidance with an inherited annuity, consider working with a financial advisor.
Basics of 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, if a beneficiary is not named or if it’s not a joint and survivor annuity, which would continue paying benefits to a surviving spouse, any remaining money in the annuity would be lost. The financial institution the annuitant purchased the annuity from would get to keep any remaining benefits.
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 may want to name them as beneficiaries to a joint and survivor annuity so that they can receive any remaining benefits once you and your spouse die. An annuity can be used to supplement other financial resources, such as life insurance or a trust, inside of an estate plan.
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 inherited annuities are taxed starts with knowing the difference between qualified and non-qualified annuities.
A qualified annuity is an annuity that’s purchased using pre-tax dollars through a tax-advantaged account, such as a 401(k) plan or an individual retirement account (IRA). Any distributions paid to the annuitant from a qualified annuity are treated as taxable income in the year they’re received.
In almost all cases, withdrawals made before age 59.5 are subject to a 10% early withdrawal penalty. Qualified annuities must also follow the required minimum distribution (RMD) rules.
A non-qualified annuity, on the other hand, is funded using after-tax dollars. That kind of sounds like a Roth account but there’s a catch. The contributions made to a non-qualified annuity aren’t taxable.
However, any growth or earnings on your initial investment are tax-deferred. In other words, you have to pay ordinary income tax on the earnings part of your distributions. But, there is no 10% early withdrawal penalty to worry about and you don’t have to deal with RMDs either.
Tax Rules for Inherited Annuities
Taxes on an inherited annuity are usually dictated by your beneficiary status and how you receive payouts. If you’re the spouse of the original annuitant, then you can choose to continue receiving payments according to the annuity schedule. In that instance, any taxes owed on distributions would be deferred until you receive them.
Paying Taxes on an Inherited Annuity From a Deceased Parent or Non-Spouse
The rules work differently if you inherit an annuity and you aren’t the annuitant’s spouse. When you inherit an annuity from a deceased parent, the funds in the account will be taxed as ordinary income. When you have to pay taxes depends on how you decide to receive distributions from the annuity.
There are four ways to take money from an inherited annuity:
Ways to Take Money From an Inherited Annuity
|Payout Option||How It Works|
|Lump Sum||You could opt to take any money remaining in an inherited annuity in one lump sum. You’d have to pay any taxes due on the benefits at the time you receive them.|
|Five-Year Rule||The five-year rule lets you spread out payments from an inherited annuity over five years, paying taxes on distributions as you go.|
|Nonqualified Stretch||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.|
|Periodic or Annuitized Payout||You get payments for the remainder of your life, but the payment amount is not based on your life expectancy.|
Out of these four options, choosing the nonqualified stretch or periodic payment options would allow you to spread out tax liability for inherited annuity payments. But you’ll be waiting longer to receive all of the remaining money in the annuity. Choosing the lump-sum route or following the five-year rule would put the money in your hands faster. However, you’d take a bigger tax hit in the short term.
How to Avoid Paying Taxes on an Inherited Annuity
Unfortunately, you can’t completely avoid paying taxes when you inherit an annuity. But there are things you can do to defer payment on what you inherit. Here are some of the most common methods to avoid paying taxes on an inherited annuity:
- Surviving Spouse: Exercising your option to continue receiving payments as usual if you’re a surviving spouse is one way to maintain the tax-deferred status of an inherited annuity. Similarly, you can lower your tax exposure by opting for nonqualified stretch payments based on your life expectancy or periodic payments if you’re inheriting an annuity as a non-spouse.
- 1035 Exchange: In this method, you exchange the annuity you inherit for another annuity. The catch is that the exchange has to be similar in nature. In other words, you can’t exchange a qualified for a nonqualified annuity or vice versa to try and escape taxation. 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.
- Rollover Into an IRA: This is only an option if you also inherited the deceased annuitant’s IRA. If you inherit your father’s annuity, for example, but he didn’t have an IRA or he named your sibling as beneficiary, you wouldn’t be able to roll the annuity over to a personal IRA in your name. Assuming you’re able to roll an inherited annuity over, you’d then be subject to inherited IRA tax rules.
While you can’t avoid paying taxes on an inherited annuity, there are things you can do to minimize them. If you know you’ll be inheriting an annuity or if you own an annuity that you plan to leave to someone else, it’s helpful to understand the potential tax implications beforehand. While inheriting an annuity can provide a financial benefit, it can also result in tax headaches if you don’t prepare.
To make the inheritance transition of an annuity as simple as possible, consider including it in your estate plans. This will keep it under the care of your other important estate planning documents and accounts. These can include your will, power of attorney, bank accounts, retirement accounts and more.
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 up to three 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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