Can You Inherit An Annuity? A Guide For Annuity Beneficiaries

When Sam inherited his father’s annuity last year, he was unsure what to do. Should he take payments over time or lump sum? Would taxes eat up most of the balance? Like many annuity beneficiaries, Sam had more questions than answers.

“Annuities have become far more common in estate plans lately,” says John Smith, an annuity expert at ABC Financial. “But inheriting one is complex without knowing distribution rules, tax implications, and transfer options.”

This guide covers key considerations around inheriting or transferring annuities to avoid missteps and maximize value for beneficiaries.

Can You Inherit An Annuity?

Yes, Annuities can be inherited or transferred under certain conditions.

What Happens To An Annuity When You Die?

Purchasing an annuity allows you to provide for heirs after your passing. Annuity owners designate beneficiaries to receive any remaining payments or account balances when the owner dies.

Beneficiaries can be spouses, children, other individuals, trusts, or organizations. It’s important to properly name beneficiaries so the annuity assets transfer directly instead of going through probate.

The options available to an inheritor depend on several key factors:

Annuity Type – The taxation and benefits differ substantially between qualified (pre-tax) and non-qualified (after-tax) annuities.
Contract Terms – The specific annuity contract outlines exactly what heirs are entitled to and available distribution options.
Annuity Status – Whether payments have started or if it’s still in the savings accumulation phase impacts inheritance.
Death Benefit Provisions – The death benefit calculations and payout schedule to beneficiaries is detailed in the contract provisions.

Tax Implications On Inherited Annuities

A major factor in inheriting an annuity is understanding how the distributions will be taxed. This depends primarily on two key factors – the type of annuity and your relationship to the original owner.

Qualified Annuities – If the funds originated from pre-tax accounts like 401(k)s or traditional IRAs, then all distributions are taxed as ordinary income for non-spouse beneficiaries. Many annuities owned by retirees fall into this category.
Non-Qualified Annuities – For these after-tax annuities, only the gains above the original cost basis are taxable income for non-spousal heirs. The contributed basis is distributed tax-free.
Spousal Continuation – A surviving spouse can continue the annuity income tax-deferred by taking over the contract. No immediate taxation applies.
Inherited IRA – A non-spouse beneficiary may be able to directly transfer survivor annuity funds into an Inherited IRA account. This preserves ongoing tax deferral until the beneficiary begins withdrawals.

Given the significant tax implications, it’s vital beneficiaries consult a financial planner or tax professional to minimize their burden through smart distribution strategies. Taxes can quickly eat up a large portion of inherited assets if not handled carefully.

Annuity Payout Options for Beneficiaries – Annuity Death Benefit

When inheriting an annuity, beneficiaries typically have several options for choosing to receive the distribution. Common options include:

Lump-Sum Payment – The fastest access to funds is taking the balance in one lump-sum payment. However, this also subjects you to full ordinary income tax immediately.
Periodic Payments – You can opt to receive payments stretched over your expected lifetime. This spreads taxation of any gains over many years. Payments are based on life expectancy tables.
5-Year Rule – If this option is available, you must fully withdraw the annuity funds within 5 years of the original owner’s death. Only each year’s distribution is taxed.
Rollover to Inherited IRA – Transferring the balance to an Inherited IRA maintains ongoing tax-deferred growth. However, required minimum distributions still apply based on IRS rules.
Spousal Continuation – As mentioned, a surviving spouse may have the option to simply continue the annuity contract. This maintains the same tax treatment as the original owner.

Determining the optimal distribution strategy depends greatly on your specific situation – your age, tax bracket, liquidity needs, as well as the size of the annuity inheritance. Consulting an advisor helps navigate these complex choices.

Transferring an Annuity Contract

Beyond inheriting an annuity, some annuity contracts also permit changing ownership of the annuity during the current owner’s life through a transfer process. Reasons an owner may want to transfer their annuity to someone else include:

Updating or changing their designated beneficiaries
Moving to another annuity provider for better features or rates
Gift some or all of the annuity value to heirs as part of their estate plan

However, there are several important factors to consider before initiating an annuity transfer:

Review Contract Terms

The first step is reviewing your annuity contract to confirm transfers are even permitted. Some carriers prohibit transfers.

Surrender Charges

Transferring out of an annuity you own may incur surrender charges from that provider. Prepare for this cost.

Compare Benefits

Do a thorough comparison of the benefits, features, and costs of the potential new contract versus your existing annuity.

Meet Requirements

The new annuity carrier may impose requirements for the new owner like age, residency, financial suitability, etc.

Annuity owners should read the contract carefully, involve their financial advisors, and do thorough due diligence before initiating an annuity contract transfer. Direct transfers to another person or entity can get very complicated very quickly if not structured properly.

One approach that avoids surrender fees and maintains tax deferral is utilizing a 1035 exchange to shift from one annuity to another. This allows you to change annuity carriers or contracts while avoiding tax penalties. Both the old and new annuity must be alike though – either fixed or variable annuity products.

Alternatives to Transferring Ownership

Instead of actually transferring full ownership and rights for your annuity to someone else, you may have some alternative options to consider:

Update Beneficiary Designations – Revisiting your listed beneficiaries ensures your intended heirs will inherit the annuity. Make updates as circumstances change.
Convert to IRA – You may be able to convert your annuity to an IRA account. This provides greater flexibility in beneficiary choices and requires minimum distribution strategies.
Trusts or Joint Accounts – Setting up a trust or adding a joint owner to financial accounts provides options to control assets both before and after your death.
Qualified Charitable Distributions – Naming a charity as beneficiary escapes income tax on inherited annuities. The charity gets the full balance tax-free.

These alternatives allow you to adjust your plans as needed without permanently signing over your annuity to someone else while you are still living.

Taxation of Transfers: Key Points

Given the potential tax implications, it’s essential to understand how inherited and transferred annuity payments are taxed:

Inheritors – Owe ordinary income tax on all growth when received. Exceptions for spousal continuation allow delaying taxes.
Transfers to Individuals – May incur surrender charges plus taxes owed on any gains above cost basis. Prepare to pay taxes on earnings.
Transfers from deferred annuities before age 59.5 also incur a 10% penalty.
Movement between non-qualified annuities is income tax-free. But may still incur surrender fees.
1035 Exchanges – Allow tax-free transfer between annuities. But surrender charges often still apply.
Consult a tax pro on annuity options after inheriting or transferring to minimize taxation.

The tax treatment varies widely depending on factors like the annuity type, your relationship to the deceased, and the payout method chosen. Inheriting an annuity from a parent or other non-spouse can result in significant tax bills if not structured properly.

It’s wise to discuss the value of the annuity and payout alternatives with a financial planner experienced in minimizing taxes on inherited annuities. With proper strategy, it may be possible to mitigate the tax bite. But you must plan ahead and understand the implications before paying taxes on an inherited annuity.

Strategies to Avoid Paying Taxes On Inherited Annuity

If you currently own an annuity or will inherit one, here are some strategies to help minimize taxation:

Maximize Deferral – Leave funds in tax-deferred accounts as long as possible. Avoid lump-sum payouts if possible.

Stretch Distributions – Spreading inherited payments over time reduces tax brackets in any given year.

Rollover to IRA – Transferring to an Inherited IRA maintains tax deferral. Follow IRS rules closely.

List Spouse as Beneficiary – Surviving spouses receive the most flexibility and tax leniency.

1035 Exchange – May allow moving funds to a more favorable annuity contract.

Charitable Beneficiaries – Naming a charity eliminates income tax on the amount gifted.

Building tax planning into your overall annuity and estate strategy is crucial to preserving wealth for beneficiaries. Annuities offer unique tax advantages if set up properly.

Conclusion

Inheriting or transferring an annuity comes with several considerations:

There are various options for beneficiaries to receive inherited annuity assets.
Tax treatment depends on factors like the annuity type and payout method.
Annuity contracts may allow changing ownership, but rules and fees apply.
Consult qualified financial and tax advisors for guidance on maximizing decisions.
Properly structuring annuities with beneficiary planning supports effective wealth transfer.

While inheriting an annuity can provide valuable benefits, it also creates complex choices for beneficiaries unfamiliar with distribution rules and taxation. Working with professional advisors is key to avoiding missteps and unfavorable tax treatment. With proper planning, annuities can be a powerful way to create a legacy for your loved ones!

FAQs

If you’ve been named beneficiary for an annuity or are considering setting one up, some common questions include:

Yes, through the annuity death benefit, beneficiaries can inherit any remaining payments or account balance after the annuitant passes away.

Taxes owed depend on the annuity type, beneficiary relationship, and payout method chosen. Rules differ widely for spouses versus others.

Common options include lump sum payment, periodic lifetime payments, 5-year distribution, rollover to Inherited IRA, or spousal continuation.

For a qualified annuity, the IRS requires minimum distributions based on your life expectancy, or a 50% penalty applies.

You may be able to transfer to another annuity or Inherited IRA account. However, tax consequences may apply for nonqualified annuities.

The owner must confirm with the insurer if transfers are allowed, complete forms, get approval, and comply with their process.

You can disclaim the inheritance, allowing it to pass to a contingent beneficiary if named. Or take a lump-sum distribution, which is taxable.

The annuity may have a provision requiring the beneficiary to wait 5 years after death for withdrawals or transfers.

Yes, options like periodic payments can minimize extra taxes by spreading distributions if you’ve inherited an annuity over time.

Bara Goldberg Finance Writer

Bara Goldberg - Amanda Dobanton Esq. is a General Counsel for Fairfield Funding. She has been crucial to the growth of Fairfield Funding for the past 9 years. Prior to Fairfield, she interned at a law firm in Gwinnett County. Ms. Dobanton received a B.S. in History and Political Science from Brenau University and went on to obtain her Juris Doctorate Degree from Atlanta’s John Marshall Law School. Amanda is currently serving on the Board for the National Association of Settlement Purchasers. Amanda is a seasoned expert in the structured settlement and annuity field.

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