Annuities can provide lifetime income for retirees and they can continue paying out after the purchaser passes away. If you’re married, for example, you may name your spouse as a beneficiary. Or if you have adult children, you might like them to inherit your annuity later. Passing on an annuity can have some tax implications, however. The tax rate on an annuity can depend on who inherits it and how the annuity is structured. A financial advisor can help you navigate this and other financial conundrums.
What Is an Annuity and Who Can Inherit One?
An annuity is an insurance contract made between a purchaser, called an annuitant, and an annuity company. The annuitant pays a premium to the annuity company with the agreement that the annuity company will eventually make payments back to the annuitant. When this happens can depend on whether the annuity is immediate or deferred.
Immediate annuities typically begin paying out to the purchaser within one year of establishing the contract. Deferred annuities may not begin making payments for several years. For example, you might buy an annuity at age 55 with the agreement that you’ll begin receiving payments at age 65.
When you purchase an annuity, you can name one or more beneficiaries who will inherit it after you pass away. Your annuity beneficiary can be a spouse, child, parent, sibling or another relative. Keep in mind that if you’re naming a child or grandchild who’s a minor, they won’t be able to access any inherited annuity benefits until they become adults.
What Happens to an Annuity When the Owner Dies?
If an annuity is structured to include one or more beneficiaries, those individuals will continue to receive payments from the contract after the annuitant passes away. The amount they’re entitled to receive may represent the money remaining in the annuity itself or a guaranteed minimum amount. Again, this will depend on how the annuity is structured.
The beneficiary may be able to choose how they’d like to receive these payments. If the beneficiary is a spouse, then they may be able to continue receiving payments according to the schedule established by the original annuity contract. If the beneficiary is not a spouse or they are but they’re not able to continue the payments as scheduled in the original contract, then they may have their choice of:
- Lump-sum distribution
- Payments based on their life expectancy
- Incremental payments made over a five-year period
- Annuitized payments not based on life expectancy
These payments are not tax-free, however. The beneficiary’s relationship to the purchaser and the payout option that’s selected can determine how an inherited annuity is taxed.
Qualified vs. Non-qualified Annuity
What you’ll pay in taxes for an inherited annuity can depend on whether the annuity is qualified or non-qualified. Qualified annuities are funded with pre-tax dollars; non-qualified annuities are funded with after-tax dollars.
Here’s why the distinction matters. Qualified annuities require those who inherit them to pay taxes on all of the withdrawals. You may also have to take required minimum distributions (RMDs) from a qualified annuity you inherit.
With non-qualified annuities, only the earnings are taxed; the principal is not. There are no RMDs to worry about either.
Tax Rate on an Inherited Annuity
Inherited annuities are considered to be taxable income for the beneficiary. So the tax rate on an inherited annuity is your regular income tax rate. Taxes are due once money is withdrawn from the annuity.
Annuity Taxes for Surviving Spouses
Generally, the best way for surviving spouses to minimize tax liability on an inherited annuity is to take the payments based on their life expectancy. They won’t avoid the tax entirely but they could pay less in taxes overall.
If the beneficiary opts for a lump-sum distribution, on the other hand, they’ll owe taxes on the difference between what the annuity was purchased for and its death benefit. This route usually carries the biggest tax bite.
A spouse who chooses the five-year distribution will owe tax on the difference in value on the amount withdrawn. This could prevent them from getting nudged into a higher tax bracket which could trigger a higher tax rate for inherited annuity benefits.
Annuity Taxes for Non-Spouses
If you inherit an annuity but you were not the purchaser’s spouse then you wouldn’t be able to change ownership of the contract. But you could still choose between taking a lump sum, payments over a five-year period or payments based on your life expectancy.
Again, taking a lump sum would likely trigger the highest tax liability while spreading out payments based on life expectancy would allow you to pay less in taxes. One thing to keep in mind is whether the annuity you inherit is an IRA annuity.
Under the terms of the SECURE Act, those who inherit an IRA annuity have to withdraw all of the money in it within 10 years following the death of the original owner. Failing to withdraw the required amount could trigger a 50% tax penalty on any remaining amounts. Exceptions to this rule are allowed for spouses, minor children and beneficiaries with disabilities or chronic illnesses.
Rolling Over an Inherited Annuity
If you expect to inherit an annuity, one possibility for minimizing taxes on it is rolling it over into a new annuity. You may be able to do this if you’re inheriting a qualified annuity and the new annuity is also qualified. This type of rollover can be executed without incurring a tax penalty.
Another possibility is rolling an inherited annuity into an IRA. You could only do this if you also inherited an IRA from the annuitant. If you’re able to roll an inherited annuity into an IRA, the money would then be subject to inherited IRA tax rules.
Talking to your financial advisor or a tax professional can when you’re unsure of the best way to handle an inherited annuity. And it can also be helpful if you plan to purchase an annuity and leave it to your spouse, child or another beneficiary.
The Bottom Line
The tax rate on an inherited annuity is determined by the tax rate of the person who inherits it. If you expect to inherit an annuity, it’s important to consider beforehand how that might affect your tax situation. Estimating what you might owe in taxes can help you decide which payout option makes the most sense.
Tax Planning Tips
- Consider talking to a financial advisor about your options for minimizing taxes on an inherited annuity. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You might also want to talk to your advisor about the pros and cons of using an annuity for retirement planning. While annuities can be useful for creating a guaranteed stream of income, there are some potential downsides. For example, annuity fees can quickly add up. Talking over the advantages and disadvantages can help you decide if an annuity is right for you.
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