When someone purchases an annuity, they agree to either pay a lump sum or make a series of payments to the issuing insurance company. In exchange, the insurance company sends the annuity purchaser regular payouts — either immediately or at a later date. Some annuities have built-in death benefits but for those that don’t, the annuity owner may add riders that provide these provisions.
Read on to learn what happens when you inherit an annuity and how to plan for the future.
If you inherit an annuity, you take over the contract between the original owner and the issuing insurance company. Three primary factors influence how you receive the funds:
Two regulations can affect how quickly you must withdraw your funds: The five-year and 10-year rules. These don’t impact all annuities, though — here’s how they work.
Non-qualified annuities require beneficiaries (typically non-spouses) to withdraw the entire balance within five years of the original owner’s death
You have a little flexibility here, as there are no required minimum distributions (RMDs). Instead, you can take out the money immediately, withdraw smaller amounts, or wait until the end of the five years.
This only applies to annuities that are held within inherited IRAs. The Secure Act of 2019 says most non-spouse beneficiaries must take out all the IRA’s funds within 10 years of the original owner’s death.
You may also be subject to RMDs, depending on whether or not the original IRA owner had started taking these withdrawals.
Children, individuals with disabilities, and spouses may be exempt from the 10-year rule or have alternative options, allowing for more flexibility in managing inheritance.
Here's a breakdown of three common inherited annuity distribution rules.
When you opt for lump-sum distributions, you’ll receive the entire value of the annuity in one payment. This can be a great option if you need immediate access to your funds — whether for an emergency, an investment opportunity, or a life goal.
But a complete withdrawal means the funds will no longer benefit from tax-deferred growth within the annuity. Unless you reinvest the money wisely, you might miss out on the long-term benefits of keeping the contract open.
Additionally, any taxable portion of the annuity, such as the growth, will count as income in the year you take the lump sum. Depending on the amount, this could push you into a higher tax bracket, so it’s wise to factor that into your decision.
Taking payouts over time turns your inheritance into a regular income stream. This option gives you fixed yearly, quarterly, or monthly payments for a set number of years.
Depending on your own life expectancy, you’ll be required to take out a certain amount annually. And you’ll often need to start taking payments within a year of the annuity owner’s death.
If you’re the spouse of the original annuity holder, you may have the option to continue the annuity as if it were your own. You would get to keep all the benefits and guarantees of the original contract, including any unique features or protections like annuity riders.
You would also gain more control over the annuity, which would allow you to make changes or start taking payments when it suits your financial needs. This level of flexibility can be handy if your financial situation changes over time.
An inherited annuity may be subject to taxes. The amount you would owe depends on several factors, including the type of annuity and how you choose to withdraw the funds.
The first thing to determine is whether your inherited annuity is qualified or non-qualified. Purchasers fund qualified annuities with pre-tax dollars, which delays taxes until the payout phase. Distributions are taxed as ordinary income, meaning you’ll pay inherited annuity taxes on the full amount you receive.
But if you inherit a non-qualified annuity, then the original owner purchased it with after-tax dollars. So, when you take a distribution, only the earnings or growth portion would be taxed and not the original principal.
By reducing your taxes, you’ll keep more of your inheritance working for you — here’s how.
If the inherited annuity’s terms don’t meet your needs, a 1035 exchange might be a good solution. You can transfer the annuity to a new one without immediate tax payments. This lets you choose an annuity with features better suited to your goals, whether that may be a different payout structure or enhanced benefits. Plus, you can maintain tax-deferred growth on the new annuity, allowing your money to grow without tax implications during the transfer.
Taking periodic payments instead of a lump sum makes it much easier to manage your taxes. You’ll likely stay in a lower tax bracket, which may help you avoid a huge bill. It’s a simple way to keep your finances on track and minimize expenses.
If you inherit an IRA alongside your annuity, you may roll your annuity funds into the retirement account, also called a beneficiary IRA. With this option, you wouldn’t be subject to taxes immediately. Instead, you would transfer the funds into the inherited IRA’s holdings.
You may not be able to contribute anything to this account aside from your inherited investments, but your money would grow tax free until you start taking payments.
This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.
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