Inheriting money can be a bittersweet experience. While it’s a thoughtful gesture from a loved one, understanding how to manage the windfall can be tricky.
If the inheritance includes an annuity, things can get complicated quickly. It isn’t like inheriting a Roth IRA or brokerage account. Instead, inheritance rules around annuities largely depend on the fine print in the annuity contract itself. Taxation can be tricky, too. That’s why It’s important to understand your options before making any decisions.
We’ll walk you through the process of inheriting an annuity, from how it works to the tax implications of different payout options.
Here’s what you need to know.
How does inheriting an annuity work?
An annuity is a financial product sold by insurance companies. It’s a contract where the annuitant pays a lump sum or a series of premiums in exchange for a guaranteed income stream in the future.
What happens to an annuity after the owner passes away hinges on the specific details outlined in the contract. Some annuities cease all income payments upon the owner’s death.
Meanwhile, other annuities offer a death benefit. This feature allows the owner to designate a beneficiary, like a spouse or child, to receive the remaining funds. The payout can take the form of either the entire remaining balance in the annuity or a guaranteed minimum amount, usually whichever is greater.
If your loved one had an annuity, the contract will serve as your guide. It will clearly identify the beneficiary and potentially outline the available payout options for the death benefit. Having this information handy can help you navigate the process of receiving your inheritance.
New to annuities?
Annuities are complex and a bit different than other financial products. Learn how annuity fees and commissions work and the common annuity terms that every investor should know. You may also want to consult with a financial advisor if you’re d with an annuity.
How annuity death benefits work
An annuity’s death benefit guarantees a payout to a designated beneficiary after the owner passes away. However, the specifics of this benefit can vary depending on the type of annuity, when the owner died and any optional riders added to the contract.
Here’s a breakdown of common death benefit options.
- Standard death benefit: This is the most basic — and usually free — option. It pays the beneficiary at least the amount of money contributed by the original owner, minus fees and withdrawals. Interest aside, if you contributed $100,000 initially, then withdrew $50,000 in monthly payouts over a few years, your heirs would receive $50,000 minus fees.
- Guaranteed increase death benefit: This option works like a standard annuity death benefit but increases the payout, which is based on your initial investment, by a small percentage each year. As an heir, you’d receive either the current value (aka the standard death benefit) or the guaranteed increase (the standard + 10 years of, say, 3 percent annual growth). You’d get whichever one is greater.
- Annuity death benefit riders: These optional clauses offer a higher payout compared to the standard option, and are added to an annuity contract for a fee. A stepped-up benefit rider guarantees the beneficiary receives the highest value the annuity ever reached, minus any fees and withdrawals, or the current value, whichever is more. This protects against market downturns but comes with a higher annual fee.
Understanding the different death benefit options within your inherited annuity is important. Carefully review the contract details or speak with a financial advisor to determine the specific terms and the best way to proceed with your inheritance.
Annuity distribution options
Once you inherit an annuity, you have several options for receiving the money. You can choose to receive the money all at once — which comes with significant tax implications — or spread payments out over time to minimize the tax bite. In some cases, you might be able to roll the annuity into a special type of individual retirement account (IRA).
Lump sum payment
You can choose to receive the entire remaining balance of the annuity in a single payment. This option offers immediate access to the funds but comes with major tax consequences. Since you’re receiving the entire amount at once, you must pay taxes on the entire annuity when tax time rolls around.
Roll over an annuity
If the inherited annuity is a qualified annuity (that is, it’s held within a tax-advantaged retirement account), you might be able to roll it over into a new retirement account. You don’t need to pay taxes on the rolled over amount.
Beneficiaries can roll funds into an inherited IRA, a unique account specifically designed to hold assets inherited from a retirement plan. Spouses have the most flexibility, and can take withdrawals for the rest of their life. Other types of beneficiaries generally must withdraw all the funds within 10 years of the owner’s death.
While you can’t make additional contributions to the account, an inherited IRA offers a valuable advantage: tax-deferred growth. Earnings within the inherited IRA accumulate tax-free until you start taking withdrawals.
When you do take withdrawals, you’ll report annuity income in the same way the plan participant would have reported it, according to the IRS.
Payout over time
You can choose to receive the annuity payout in installments, similar to how the original owner would have received them. This option provides a steady stream of income, which can be beneficial for long-term financial planning.
There are different payout options available. Generally, you must start taking distributions no more than one year after the owner’s death. The minimum amount you’re required to withdraw each year after that will be based on your own life expectancy.
Stretching payments out over time also softens the tax hit of inheriting an annuity since you won’t owe taxes on the entire annuity all at once.
As a beneficiary, you won’t be subject to the 10 percent IRS early withdrawal penalty if you’re under age 59½.
Tax implications of an inherited annuity
Trying to calculate taxes on an inherited annuity can feel complex, but the core principle revolves around whether the contributed funds were previously taxed.
- Non-qualified annuities: These annuities are funded with after-tax dollars, so the beneficiary generally doesn’t owe taxes on the original contributions, but any earnings accumulated within the account that are distributed are subject to ordinary income tax.
- Qualified annuities (IRAs, 401(k)s): These annuities are funded with pre-tax dollars, meaning the beneficiary will owe ordinary income tax on the entire amount withdrawn, including both the initial investment and any earnings. There are exceptions for spouses who inherit qualified annuities. They can generally roll the funds into their own IRA and defer taxes on future withdrawals.
Either way, at the end of the year the annuity company will file a Form 1099-R that shows how much, if any, of that tax year’s distribution is taxable.
In some situations, you may also need to calculate estate and inheritance taxes. These taxes target the deceased’s total estate, not just the annuity. However, these taxes typically only impact very large estates, so for most heirs, the focus should be on the income tax implications of the annuity.
Bottom line
Inheriting an annuity can be a complex but potentially financially beneficial experience. Understanding the terms of the contract, your payout options and any tax implications is key to making informed decisions. Speaking with a financial advisor can help you navigate these complexities and maximize the benefit of your inheritance.
