Inherited Annuity Guide for Beneficiaries (Tax Implications + More)

An annuity is a terrific option for your retirement plan. The goal of an annuity is to generate a dependable stream of income for your retirement. In fact, some annuities can provide you with a steady income stream for the rest of your life.

But what happens if you die before the annuity finishes paying out? In these cases, a death benefit feature comes in handy. Most annuities have a death benefit feature that lets you pass on the annuity’s assets to a beneficiary after your death.

If you already have an annuity or you’re just thinking of purchasing one, you need to know about annuity death benefits. In this post, we’re covering what inherited annuities are and how they work.

Can You Inherit an Annuity? Death Benefits Explained

An annuity is a contract between you and an insurance company. You pay the insurer a set amount of money, and in turn, the insurer agrees to pay you according to a set schedule.

There are many different types of annuities. They differ based on when you receive the payments, how the money grows, and how the annuity is taxed.

For example, with an immediate annuity, payments can begin right away. But with a deferred annuity, payments are deferred until a later date.

Your annuity contract may include a standard death benefit. This ensures that a beneficiary inherits the annuity and either receives a lump-sum payout or receives a series of annuity payouts when you die.

In that sense, it’s similar to a life insurance policy, although there are some key differences. In an annuity, death benefits pay out differently, and your beneficiary may face different tax liabilities.

Annuity Benificiary Payout Options

The annuity death benefit can help create a financial legacy.

For example, you could leave money to your spouse to help fund their retirement. Or, you could name one of your children as beneficiary and fund or increase their inheritance. You could even reinvest an inherited annuity to fund another annuity. Heirs can take an annuity death benefit as a lump sum payment or as regular periodic payouts.

Lump-Sum Payment

With a lump-sum payment, the designated beneficiary receives the balance of the annuity and will need to manage the tax implications that go along with it. Income taxes will apply to the interest earned on the original deposit amount.

Periodic Payments

Annuity beneficiaries can also choose to receive periodic payments either in the form of a single-life option or a term-certain annuitization option. With a single-life annuity payout, money is typically distributed monthly until the beneficiary’s death. If there is still a balance after they die, the remainder is surrendered to the insurance company. With a term-certain option, periodic payments can also be period-certain.

These annuity payments are disbursed for a set fixed period of time, such as 10 years. Once the term has ended, the annuity beneficiary receives no more payments.

Five-Year Rule

The five-year rule requires that the beneficiary withdraws the entire balance of the annuity within five years of the owner’s death.

With the Five Year Rule, the beneficiary has several options regarding when to receive the death benefit proceeds:

• Take all the money out soon after the death of the owner
• Take periodic payments at any time during the five-year period
• Wait until the fifth year to take all the annuity proceeds at once

The internal revenue service (IRS) taxes annuity income to the extent of gains distributed from the contract, and gains are distributed first. If a trust, charity, or estate is the beneficiary of a non-qualified deferred annuity, the five-year rule is the only rule they must abide by.

Inherited Annuity Tax Implications

Once the money is inside of an annuity, it grows tax-free (or rather, tax-deferred), so the policyholder does not have to pay taxes on the growing account balance. Once the annuity enters the annuitization phase, they must begin paying taxes on earnings, as well as any other untaxed portions.

A typical rule for annuities is last-in, first-out. This means the IRS views the untaxed portion as coming out first when you make a withdrawal. When you inherit an annuity, you assume what is referred to as the “owner’s basis,” which means you own the amount of already-taxed money in the account.

And you have the same amount of annuity income as the owner would have. For example, if half of the contract is basis; then half is gain. When an annuity payment is made, 50% of each payment would be income taxable. If the payout is over an annuitant’s lifetime, and the annuitant outlives life expectancy, all further payments are subject to ordinary income as received. The type of annuity you inherit affects your tax implications.

Tax liabilities differ depending on funds the owner used to buy the annuity in the first place (qualified vs. non-qualified).

Inherited Qualified Annuity Taxes

With qualified annuities, funds come from pre-tax dollars. This means the owner paid no taxes, not even on the principal.

As the account grew, it accumulated earnings without a tax liability. In other words, all of the funds were sheltered from income taxes while in the account. But with a qualified annuity, you must pay taxes on all of the withdrawals. So, when you inherit a qualified annuity, Uncle Sam comes calling! Since the owner didn’t pay taxes on any of the money, all of the death benefit withdrawals are considered income.

Therefore, they’re subject to ordinary income tax rates. If you inherit this type of annuity, be prepared to pay taxes on the entire withdrawal. You are also required to take distributions from the annuity pursuant to the applicable required minimum distribution (RMD) rules.

Inherited Non-Qualified Annuity Taxes

With non-qualified annuities, funds come from post-tax dollars. This means the money was already taxed before it was put into the annuity. Because the annuity purchaser invested after-tax dollars, the principal isn’t taxed when distributed.

Therefore, you only pay taxes on the earnings. Earnings are taxed as ordinary income and don’t receive any special capital gains treatment. In this sense, the taxation of the earnings is similar to taxation of 401(k)s, non-Roth IRAs and other qualified retirement plans.

If you inherit a non-qualified annuity, be prepared to pay taxes on the earnings. But, there is no 10% early withdrawal penalty to worry about. Plus, you don’t have to deal with RMDs, like you do with qualified annuities.

Survivor Annuity Options

If the Spouse is the Beneficiary

If the annuity’s owner dies before annuity payments begin, and the owner’s spouse is a joint owner or the sole beneficiary, the spouse can continue the contract as the owner.

After a change in ownership, the contract continues as if the surviving spouse owned the original contract. It keeps its valuable tax-deferred status, meaning the beneficiary owes no immediate taxes, and they will begin to receive the payments as stated in the original contract.

The lowest tax exposure option is for the surviving spouse to have the death benefits paid over their life expectancy. However, the spouse could also choose to take an immediate lump sum. In this situation, the beneficiary-spouse will owe taxes on the entire difference between what the owner paid for the annuity and the death benefit. Lump-sum distribution is the option with the highest tax consequences for the surviving spouse.

The spouse can also choose to withdraw the money over a set period of five years (the five-year rule). With this distribution option, the spouse will owe taxes only on the increased value of the withdrawn portion. This option makes it less likely that the spouse will fall into a different, perhaps higher, tax bracket. Going to a higher tax bracket means paying the IRS more in taxes.

If Someone Besides the Spouse is Beneficiary

If the annuity was an IRA annuity, the SECURE Act, that went into effect on January 1, 2020 stipulates that if you inherit an IRA, you'll now generally have 10 years after the account holder's death to withdraw all the money.

If you don’t, you'll face a 50% penalty on any money remaining in the account. There are exceptions. This rule doesn't apply to the account holder's spouse and children who are minors. Further, beneficiaries who are disabled or chronically ill and beneficiaries who are within 10 years of the age of the original account holder are also exempt from the 10 year rule.

3 Three Simple Things to Know as the Beneficiary of an Annuity

Inheriting an annuity can be confusing. But it doesn’t have to be. Just remember the following three things about annuities and their death benefits:

1. All retirement plans that include annuities should have some type of legacy plan in place. It's a good idea to work with a qualified professional when it comes to any tax questions related to your legacy.
2. Annuity owners should clearly understand their death benefit options, and they should explain them to their spouse and non spouse beneficiaries. It's a good idea to consult with a tax professional to discuss the most efficient and appropriate way to structure any distributions when the owner dies.
3. Like life insurance, the owner of an annuity can change beneficiaries at any time. That's good to know if there are changes in family dynamics, like the death of a spouse or divorce.

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Citations

1. Zacks (Cross) -- Do I Pay Taxes on All of an Inherited Annuity or Just the Gain?

2. Smart Asset (Lake, 2019) -- Understanding Annuity Death Benefits

3. Wealth Management (Duncan 2020) -- Helping an Annuity Beneficiary Understand Distribution Options

4. The Street (Dan the Annuity Man, 2020) -- Annuity Death Benefits: How They Are Paid Out