What Happens When I Inherit an Annuity?

An annuity is a contract with an insurance company where a sum of money is exchanged for regular payments. When someone inherits an annuity, they become the designated beneficiary of such a contract following the original owner’s death. Navigating an inherited annuity involves understanding distribution options and the associated tax rules, as each decision carries financial implications.

Understanding Inherited Annuity Basics

An inherited annuity is an annuity contract where the original owner has passed away, and its value is now payable to a named beneficiary. The original owner is known as the annuitant, whose life typically determines the payment schedule. The beneficiary is the person designated to receive the contract’s value upon the annuitant’s death.

Annuities are broadly categorized into two types based on their tax treatment: qualified and non-qualified annuities. A qualified annuity is held within a tax-advantaged retirement account, such as an Individual Retirement Account (IRA) or a 401(k), meaning contributions were often made on a pre-tax or tax-deferred basis. Conversely, a non-qualified annuity is purchased with after-tax money.

For non-qualified annuities, the cost basis represents the amount of after-tax money the original owner contributed. The contract value includes both the original contributions and any accumulated earnings. When a beneficiary inherits a non-qualified annuity, only the earnings portion, which is the difference between the contract value and the cost basis, is subject to income tax.

Choosing a Beneficiary Distribution Method

When inheriting an annuity, beneficiaries have several options for receiving the funds, often depending on their relationship to the deceased owner. A surviving spouse generally has the most flexibility compared to non-spousal beneficiaries.

A surviving spouse may choose a spousal rollover, treating the inherited annuity as their own. This allows the spouse to become the new owner, effectively continuing the tax-deferred status of the funds. The spousal rollover can be accomplished by directly transferring the funds to an existing IRA or a new annuity contract in the spouse’s name. Alternatively, a surviving spouse can elect to continue the existing annuity contract, stepping into the role of the new annuitant and owner. While a lump sum distribution is also an option, it can trigger immediate taxation on the accumulated earnings.

Non-spousal beneficiaries face different rules for receiving inherited annuity funds. One option is to take a lump sum distribution, which provides immediate access to the entire value of the annuity. Another common choice is the five-year rule, which requires all funds to be distributed by the end of the fifth calendar year following the original owner’s death. This rule typically applies if the original owner died before annuity payments began or for certain non-qualified contracts.

The stretch option, also known as the life expectancy method, previously allowed beneficiaries to take distributions over their own life expectancy, continuing tax deferral. However, the SECURE Act significantly altered this option for most non-eligible designated beneficiaries. Many non-spousal beneficiaries are now subject to the 10-year rule, which mandates that the entire inherited annuity must be distributed by the end of the tenth calendar year following the owner’s death. This 10-year period provides flexibility in when withdrawals are taken, but the full value must be withdrawn within the decade.

Another method available for beneficiaries is annuitization, which involves converting the inherited annuity’s value into a series of guaranteed periodic payments. These payments can be structured to occur over a set number of years or for the beneficiary’s lifetime. This option provides a predictable income stream, similar to a traditional annuity payout, and can help manage the tax burden by spreading it over time.

Tax Implications of Inherited Annuities

The growth or earnings portion of an inherited annuity is generally subject to taxation as ordinary income for the beneficiary. The specific tax treatment depends on whether the annuity was qualified or non-qualified.

For qualified annuities, such as those held within an IRA or 401(k), the entire distribution, including both the original contributions and any earnings, is generally taxable as ordinary income. An exception exists if the original owner made after-tax contributions to the qualified plan; in such cases, only the portion representing pre-tax contributions and earnings would be taxable upon distribution.

Non-qualified annuities are treated differently for tax purposes. Only the earnings, which represent the difference between the contract’s current value and the original after-tax contributions (cost basis), are subject to ordinary income tax. If the beneficiary chooses to annuitize the payments, an “exclusion ratio” is applied, allowing a portion of each payment to be considered a tax-free return of principal, while the remainder is taxed as income. For non-periodic withdrawals, such as a lump sum or partial withdrawals, the “gain first” rule, also known as Last-In, First-Out (LIFO), applies. This means that all earnings are considered to be withdrawn first and are fully taxable until all accumulated gains have been distributed, after which any further withdrawals are considered a tax-free return of principal.

Inherited annuities are also subject to Required Minimum Distributions (RMDs) under specific circumstances, particularly for spousal rollovers, certain stretch options, and the 10-year rule. While RMDs dictate the minimum amount that must be withdrawn annually, these required withdrawals are fully taxable as ordinary income to the beneficiary. The 10% early withdrawal penalty, typically imposed under IRS Section 72 for withdrawals before age 59½, generally does not apply to inherited annuities due to an exception for distributions made to a beneficiary after the death of the contract owner.

In addition to federal income taxes, distributions from inherited annuities may also be subject to state income taxes, depending on the beneficiary’s state of residence. State tax rules vary widely. The annuity company will issue Form 1099-R to the beneficiary, which reports the taxable distribution amount to both the Internal Revenue Service (IRS) and the beneficiary.

Navigating the Administrative Process

Claiming an inherited annuity involves a series of administrative steps. The initial phase focuses on gathering necessary information and documents. Beneficiaries should search for the original annuity contract, any beneficiary designation forms, and recent account statements.

It is also important to gather personal identification documents for the beneficiary, such as their Social Security Number or Taxpayer Identification Number, along with a certified copy of the original owner’s death certificate. Once these documents are in hand, the beneficiary should promptly notify the annuity company of the owner’s death. This notification can typically be done through a phone call, online portal, or written notice.

Upon notification, the annuity provider will generally send specific beneficiary claim forms. These forms are designed to collect the beneficiary’s personal information, confirm their identity, and allow them to formally elect their chosen distribution method. The forms typically request details such as the beneficiary’s full name, current address, Social Security Number, and banking details for direct deposit of funds.

Complete and submit these claim forms along with all required supporting documents. Review your chosen distribution option to ensure it is correctly indicated on the forms. The completed package can usually be submitted via mail, secure online portal uploads, or sometimes by fax. After submission, beneficiaries can expect a processing period, which can range from a few weeks to a couple of months, during which the company may confirm receipt and potentially request additional information. Distributions will commence according to the chosen method, and the annuity company will issue Form 1099-R at year-end to report the taxable amounts received.