Annuities are complicated products that often cause much confusion for annuity owners, let alone their beneficiaries. There can be significant tax consequences associated with the inheritance of an annuity held in a non-qualified account that can substantially impact the total dollars received by a non-spouse beneficiary.
If you are the beneficiary of an annuity, there are several options to consider. For purposes of an example, consider the following situation:
Upon her mother’s death, Susan inherits an annuity held in a non-qualified account. The value of the annuity is $500,000 and the cost basis (the amount her mother paid into the annuity) is $200,000.
Option 1 – Take an immediate lump sum payment.
The difference between what was paid into the annuity by the descendant and the market value would be taxable at the beneficiary’s ordinary income tax rate. The proceeds can be deposited into any non-qualified account and used or invested as the beneficiary chooses.
- Per our example, Susan would receive $500,000. $300,000 would be taxable to Susan at her ordinary income tax rate and need to be reported as income on her taxes in the year of receipt.
Option 2 – Stretch the payment over 5 years.
The entire payment must be paid out over 5 years, in any combination of payments. The distributions that represent gains (the difference between the market value at the cost basis) are taxable at ordinary tax rates. The portion of the account that represents gains are assumed to come out first.
- Assuming payments were made in equal installments, the $100,000 distributed in years 1-3 would all be taxable at Susan’s ordinary income tax rates. The $100,000 distributed in years 4-5 would not be taxable.
- In some cases, there may be the opportunity to use a 1035 exchange to help mitigate the tax repercussions of a 5-year payout by having a portion of each $100,000 payment be taxable and a portion tax-free.
Option 3 – Annuitize over the beneficiary’s lifetime.
A portion of each distribution would be taxed at ordinary income tax rates and portion would be tax-free (referred to as the exclusion ratio).
- Based on our example, 60% of each payment would be taxable at Susan’s ordinary income tax rate and 40% would not.
Given that most non-spouse beneficiaries are substantially younger than the annuity owner, it is rare for Option 3 to be selected. Once an election to annuitize is made, the beneficiary can only receive the income stream – he or she no longer has access to any of the principal.
If you are named as a non-spouse beneficiary of an annuity that is held in an IRA, you have two options: (1) you could either take the entire amount as a lump sum distribution and pay ordinary income tax on the entire amount or (2) you can retitle the IRA as an Inherited IRA, and the rules regarding IRA distributions for non-spouse beneficiaries would apply. See https://www.core-wm.com/2014/05/08/a-non-spouse-as-beneficiary-of-an-ira/
If you inherit an annuity, it is important that you contact your tax advisor or financial planner to determine the best way for you to collect that inheritance. As you can see, taxes can drastically effect the total dollars that you ultimately receive.