The loss of a loved one is never easy — to put it mildly. When you go through something like that, it can be emotionally overwhelming, so dealing with the financial aftermath can feel like wandering a maze in the dark. As such, it might be a mix of relief and confusion for you to discover that you are the designated beneficiary of an annuity.
Despite this, there is one silver lining. The remaining contract value is paid to the beneficiaries as a death benefit, bypassing the lengthy, public, and often costly probate process.
The next step, however, isn’t automatic. Depending on the contract’s specific terms, whether the original owner has already started receiving payments, and your legal relationship to the deceased, you will have to decide which payout method to use and what the tax implications are.
If you understand your options right now, you can make the most of this financial gift and prevent a massive, unnecessary tax burden in the future. With that said, here’s a guide to understanding inherited annuities.
The Four Major Beneficiary Payout Options
If you inherit an annuity, the insurance company will present you with a few options. Rather than viewing these choices through the lens of “how fast can I get this money?” it’s worthwhile to consider “what will this look like on my next tax return?”
1. Lump-sum payout.
The easiest and fastest way to access the funds is with a lump-sum payout, which distributes the entire remaining balance of the annuity at once. It might sound incredibly tempting to withdraw the entire balance immediately into your bank account, but it comes with a major financial risk.
Since annuities grow tax-deferred, original owners haven’t been taxed on their investment gains. If you take a lump sum, all those accumulated, taxable gains will be realized in the same calendar year. As such, you could instantly end up in a much higher federal and state income tax bracket if the annuity grew significantly. This would force you to hand over a huge portion of your inheritance to the IRS.
2. The 5-year or 10-year rule.
You can avoid a steep, single-year tax spike by withdrawing over a multi-year period. Nevertheless, the timing rules are rigid, and assuming you have full freedom in distribution timing can be a very costly mistake.
- The 10-year deadline. Generally, non-spouse beneficiaries (such as adult children) must withdraw the entire inherited account by December 31 of the 10th year following the original owner’s passing.
- The 5-year deadline. An alternative payout option called the 5-year rule is triggered if the original owner died before their Required Beginning Date (RBD) and you are not an “Eligible Designated Beneficiary.”
Withdrawals can’t always be delayed.
Many people assume that, under the 10-year rule, you can simply wait, leave the account untouched for the first nine years, then empty it in year ten.
According to IRS final regulations, this is a trap. From years one through nine, if the original annuity owner passed away after their Required Beginning Date (RBD), you are required to make annual Required Minimum Distributions (RMDs). The account cannot simply be cleared at the end of the year.
Who actually gets to “stretch” payments?
Typical non-spouse beneficiaries no longer have access to true “stretch” payments, where they draw small distributions over several decades. The IRS limits stretching to certain “Eligible Designated Beneficiaries” (such as disabled, chronically ill individuals, minor children, or beneficiaries less than 10 years younger than the deceased). However, surviving spouses retain the ultimate flexibility and may choose to stretch or roll over the annuity over the course of their lives.
There’s no way you can guess these rules or avoid the harsh IRS penalties, which impose a devastating 25% excise tax if you miss or don’t take enough RMDs. If you have an inherited contract, it’s recommended that you consult a qualified tax advisor, read IRS Publication 575, and study IRS Retirement Topics for Beneficiaries.
3. Annuitization vs. installment payments.
Rather than taking a lump sum, you might consider structuring your inherited distributions for long-term financial security. However, you will have to make an important decision when you choose this option between true annuitization and structured installment payments. Despite their similarity, each option impacts your liquidity, guarantees, and tax obligations entirely differently.
True annuitization.
Based on your own life expectancy, you convert the contract’s total balance into a series of guaranteed payments (such as monthly, quarterly, or annual checks).
- Pros. With this option, you’ll enjoy rock-solid, long-term financial security and longevity protection. Essentially, it provides you with a stream of income that you cannot outlive.
- Cons. In general, annuitization is permanent and irreversible. As soon as you sign the paperwork and begin receiving payouts, you will lose access to the rest of the lump sum. If an emergency arises, you cannot alter your schedule or borrow additional funds.
Installment payments (systematic withdrawals).
Instead of turning over the contract to the insurer for a guaranteed income stream, you can systematically withdraw funds over time (such as the 5- or 10-year rule) or set up a custom, systematic withdrawal plan.
- Pros. There are two main benefits here: flexibility and control. The principal of the contract remains invested and is capable of further growth, but you retain control. Whenever you need extra cash, you can withdraw it.
- Cons. As the balance is not locked into a permanent insurance guarantee, you are not protected against longevity risk. The funds may run out if you withdraw too much too quickly or if the market underperforms.
How taxes work.
Regardless of whether the contract is qualified or non-qualified, spreading payments out allows the remaining balance to continue growing tax-deferred. Furthermore, inherited annuities do not receive a step-up in basis at death like inherited stocks or real estate. As a result, you will receive the original cost basis.
- Non-qualified annuities. If the contract was funded with after-tax money (ordinary savings), your payments will be taxed based on the IRS’s Exclusion Ratio. As a result of this mathematical formula, a certain portion of every single check is a tax-free return of the original principal, while only the investment growth portion is taxable.
- Qualified annuities. The tax rules change completely if the inherited contract is part of a pre-tax retirement account, such as a traditional IRA or 401(k). Since the original funds were not taxed when contributed, the entire amount distributed is generally subject to ordinary income tax.
4. Spousal continuation: The ultimate protection.
Have you been left a surviving spouse by a deceased annuity owner? If so, you have a unique legal advantage. In particular, spouses have the exclusive right to execute a “spousal continuation.”
Rather than being forced to take an immediate distribution or trigger a standard death benefit payout, you legally acquire ownership of the existing contract. Although this can be an incredibly powerful financial planning tool, it is important to understand the IRS’s exact rules so you don’t get caught off guard.
The true benefits.
- Avoids forced liquidation. Unlike children or siblings, you do not have to liquidate the account when transferring the contract into your name.
- Preserves tax status. Tax deferral is the key advantage here. Once you take over the annuity, your accumulated, untaxed investment gains remain protected.
- Maintains contract terms. You typically retain the original contract terms, initial cost basis, and any optional features established by your spouse, such as living benefit riders.
Key nuances and restrictions.
Although spousal continuation offers many benefits, it is not a blank check to avoid taxes or rules in the future:
- Taxes apply to the next generation. Spousal continuation delays your tax bill during your lifetime, but it does not eliminate it. The remaining funds will be distributed to your secondary beneficiaries (such as your children or heirs) after you pass away. On all the accumulated, untaxed growth, those heirs will owe ordinary income taxes.
- Forced withdrawals may still apply. It’s not always possible to leave money untouched indefinitely. The IRS requires you to take Required Minimum Distributions (RMDs) once you reach the mandatory age if the annuity is qualified (inside a traditional IRA or pre-tax retirement plan). According to IRS rules and your age, specific distribution timelines may apply to non-qualified annuities funded with after-tax funds.
- “Letting the money ride” depends on the phase. Whether you can leave the principal alone depends entirely on whether your spouse has already begun taking income. In general, if the contract is still accumulating, you can let it grow. If, however, your spouse had already annuitized the contract and had been receiving guaranteed lifetime payments, those distributions must continue to be paid to you.
Timing Matters: Payout Status at the Time of Death
As a beneficiary, the actual amount available to you depends on what phase the annuity was in at the time of the owner’s death.
Before payments start (the accumulation phase).
As long as the owner passed away when funds were still being built and before the contract was converted into an income stream, your position is relatively secure. In general, annuity beneficiaries receive the full amount accumulated over the years.
Additionally, many modern contracts include a “guaranteed minimum death benefit” provision. In other words, even if the stock market crashed right before the owner passed away, the beneficiary will receive either the current market value or the total premiums paid into the account (minus any withdrawals). It effectively protects you from sudden market crashes.
After Payments Start (the annuitization phase).
As soon as the owner begins to receive regular income checks from the insurance company, the rules change significantly. If you inherit anything, it will depend entirely on the payout option selected by the original owner:
- Life-only payout. When the owner selects a standard “Life-Only” payout, all monthly payments stop permanently upon the owner’s passing. Regardless of how many checks they received before passing away, the insurance company will keep the remaining balance. However, beneficiaries do not receive a death benefit.
- Life with period certain. For example, if the contract was structured as “Life with 10-Year Period Certain” and the owner died in year four, the beneficiary is legally entitled to receive these same income checks for the remainder of the contract term.
- Life with cash/unit refund. With a refund rider, the insurance company calculates the difference between the original principal deposit and the money paid out. The remaining money is paid out as a death benefit to the beneficiary.
Final Thoughts: Look Before You Leap
When inheriting an annuity, it can be a true blessing, but if you act too fast, you could end up making a costly mistake. Schedule a brief meeting with a certified financial planner or a tax professional before signing any paperwork or checking a box on a claim form. As long as you align your payout choice with your current income and long-term financial planning goals, you can honor your loved one’s legacy while reducing your tax bill.
Image Credit: Cytonn Photography; Pexels
