Can Annuities Be Passed on to Heirs?

An annuity is a financial contract purchased from an insurance company, providing a steady income stream, often for retirement. Individuals pay premiums, either as a lump sum or over time, for future regular payments. This helps mitigate the risk of outliving savings, ensuring a predictable financial flow. Annuities typically include provisions allowing their value to be transferred to designated individuals upon the original owner’s death. This transfer involves specific considerations regarding beneficiary designation and payout options for inherited funds.

How Annuities Pass to Heirs

Annuities generally pass to heirs through beneficiary designation, a fundamental step dictating who receives the remaining value upon the owner’s death. Naming primary and contingent beneficiaries on the annuity contract ensures proceeds bypass the lengthy probate process, allowing for smoother, quicker distribution to intended recipients.

Individuals have flexibility in designating beneficiaries, which can include family members, trusts, or charitable organizations. Regularly reviewing and updating these designations is important, especially after significant life events such as marriage, divorce, or the birth of a child, to ensure the annuity aligns with current wishes. An outdated beneficiary designation could lead to unintended consequences, diverting funds from those the owner intended to support.

When an annuity owner fails to name a valid beneficiary, or if all named beneficiaries predecease the owner, the annuity’s value becomes part of the deceased’s probate estate. This can result in delays, legal complexities, and additional costs, as the asset would then be distributed according to state inheritance laws rather than the owner’s explicit wishes.

The relationship between the annuitant and the beneficiary, particularly if the beneficiary is a surviving spouse, can significantly influence the options available for receiving the inherited annuity. Spousal beneficiaries often have unique advantages, such as the ability to continue the contract as their own.

Inherited Annuity Payout Options

Upon inheriting an annuity, beneficiaries have several payout options, each with distinct implications. One common choice is the lump sum distribution, where the beneficiary receives the entire remaining value in a single payment. This provides immediate access to funds but can also trigger significant tax liability in the year of distribution.

Another option allows beneficiaries to receive payments annuitized over their own life expectancy. This “stretch” provision spreads out the tax burden over many years, potentially keeping annual taxable income lower. Payments are calculated based on the beneficiary’s age and life expectancy, providing a consistent income stream.

The “5-year rule” is a distribution requirement that applies when the original annuitant died before the annuity’s annuitization date. Under this rule, the entire value of the inherited annuity must be distributed by the end of the fifth calendar year following the annuitant’s death.

The “10-year rule” applies to most non-eligible designated beneficiaries for deaths after December 31, 2019. This rule requires the entire inherited annuity balance to be distributed by the end of the tenth calendar year following the original annuitant’s death, regardless of whether the annuitant had started receiving payments. There are exceptions for “eligible designated beneficiaries” like surviving spouses, minor children of the deceased, disabled or chronically ill individuals, and beneficiaries who are not more than 10 years younger than the deceased.

A surviving spouse often has the most flexible option, known as spousal continuation. This allows them to treat the inherited annuity as their own, effectively stepping into the original annuitant’s position. The spouse can continue to defer taxes on earnings, maintain the contract’s terms, and choose when to begin receiving payments, providing significant financial planning flexibility.

Taxation of Inherited Annuities

Taxation of inherited annuities primarily centers on the earnings portion, subject to ordinary income tax upon distribution. Unlike some other inherited assets, annuities do not receive a “step-up in basis” at death. This means accumulated gains, representing the difference between premiums paid and current value, remain taxable to the beneficiary upon withdrawal. The portion representing the original principal or cost basis is received tax-free.

Tax treatment varies depending on whether the annuity was qualified or non-qualified. A qualified annuity is held within a tax-advantaged retirement account, such as an Individual Retirement Account (IRA) or a 401(k) plan. Distributions from an inherited qualified annuity are fully taxable as ordinary income because original contributions were often made on a pre-tax basis or grew tax-deferred.

Conversely, a non-qualified annuity is purchased with after-tax dollars and is not held within a retirement plan. For inherited non-qualified annuities, only the earnings portion is subject to ordinary income tax. The original contributions, which were already taxed, are returned to the beneficiary tax-free.

The value of an inherited annuity can contribute to the deceased’s gross estate for federal estate tax purposes if the total estate value exceeds the applicable exemption amount. For 2025, the federal estate tax exemption is $13.61 million per individual. If the estate surpasses this threshold, the annuity’s value may be subject to estate tax in addition to income tax on the earnings for the beneficiary.

Beneficiaries generally do not face the 10% early withdrawal penalty that might apply to annuity owners under age 59½, even if they are below this age themselves. This exception applies because distributions are due to the death of the original contract owner. Beneficiaries should consult a tax professional to understand their specific tax obligations, as rules can be complex.