How a Non-Qualified Annuity Inheritance Works

A non-qualified annuity is a contract with an insurance company funded with after-tax money, allowing investments to grow without being taxed annually. When a beneficiary inherits such an annuity, they receive the remaining value. Navigating the rules surrounding this inheritance can be complex. This guide explains the components of the asset, the choices a beneficiary has for receiving the funds, the associated tax rules, and the steps for claiming the benefit.

Understanding the Inherited Asset

When you inherit a non-qualified annuity, you receive an asset composed of two parts: the cost basis and the earnings. The cost basis represents the total amount of after-tax dollars the original owner paid into the contract. This portion of the annuity’s value is not subject to income tax when distributed because the taxes were already paid on the contributions.

The second component is the earnings, which consists of all the interest, dividends, and capital gains that have accumulated within the annuity. This growth occurred on a tax-deferred basis, meaning the original owner did not pay taxes on these gains as they accrued. This is the portion of the inherited annuity that will be subject to ordinary income tax when you receive it.

To illustrate, if the original owner invested $70,000 into the annuity, this amount is the cost basis. If the annuity is worth $100,000 at the time of death, the remaining $30,000 represents the accumulated earnings.

Beneficiary Payout Options

A non-spousal beneficiary has several methods for receiving funds from an inherited non-qualified annuity, each with different timelines and tax consequences.

• Lump-Sum Distribution: You receive the entire value of the annuity at once. While this provides immediate access to the funds, it also means all of the accumulated earnings are taxed as ordinary income in a single year, which could move you into a higher tax bracket.
• Five-Year Rule: This allows you to withdraw the full balance of the annuity at any point within five years of the owner’s death. You have control over the timing and size of withdrawals during this period, which can help manage the tax impact by spreading the income over multiple years.
• Nonqualified “Stretch” Distribution: Some contracts may offer this option, which allows you to receive payments over your own life expectancy. This method involves calculating annual payments based on IRS life expectancy tables, turning the inheritance into a steady stream of income and spreading the tax liability over many years.
• Annuitization: This option converts the death benefit into a guaranteed series of payments. These payments can be set for a specific number of years or for the remainder of your life. Annuitization provides a predictable income stream and spreads the tax liability, but the decision is often irrevocable.

Tax Implications of Distributions

The taxation of payments from an inherited non-qualified annuity is governed by the payout option selected. For periodic payments, such as a life expectancy “stretch” or annuitization, an “exclusion ratio” is applied to every payment. This ratio separates the tax-free portion from the taxable portion and is determined by dividing the annuity’s cost basis by its total value when payments begin.

For example, if the cost basis is $70,000 and the total value is $100,000, the exclusion ratio is 70%. This means 70% of each payment is a tax-free return of the original investment, while the remaining 30% is taxable ordinary income.

For other distribution methods, the rules are applied differently. Under the Five-Year Rule, the IRS treats withdrawals on a “last-in, first-out” (LIFO) basis. This means the taxable earnings are considered to be withdrawn first before you can access the tax-free cost basis.

Special Considerations for Spousal Beneficiaries

A surviving spouse who inherits a non-qualified annuity has a unique option not available to other beneficiaries, known as “spousal continuation.” This provision allows the spouse to assume the contract and treat the annuity as their own. By electing spousal continuation, the spouse becomes the new owner, and the annuity maintains its tax-deferred status.

This is the only option that allows the funds to continue growing without triggering an immediate tax event, as other payout options require distributions to begin. By assuming the contract, the surviving spouse can postpone receiving payments and defer paying taxes on the growth.

If a spouse chooses continuation, they are not required to take required minimum distributions (RMDs) from the non-qualified annuity. They can manage the investment as if they opened it themselves, deciding when to take withdrawals based on their financial needs.

The Claims Process

After the death of an annuity owner, the first step for a beneficiary is to contact the insurance company that issued the contract and inform them of the owner’s passing. The company will then provide the necessary paperwork to begin the claims process.

You will be asked to provide specific documentation to validate the claim, which includes a certified copy of the original owner’s death certificate. You will also need to complete a claim form provided by the insurer, which gathers your personal information and confirms your status as the beneficiary.

The claim form is also where you will make your formal election for how you wish to receive the proceeds. After reviewing the available payout options, you will select your choice on this form.

Once you have submitted the completed claim form and all required documents, the insurance company will begin its internal review. Upon approval, the company will issue the payment according to the distribution option you selected.