What Is the Annuity 5-Year Rule for an Inheritance?

An annuity is a contract with an insurance company designed to provide income, often for retirement. It is funded with either pre-tax money, creating a qualified annuity, or after-tax money, resulting in a non-qualified annuity. When the owner of a non-qualified annuity passes away before all the funds have been paid out, the remaining value is transferred to a designated beneficiary.

The Internal Revenue Service (IRS) has established regulations that dictate how beneficiaries receive and are taxed on these inherited funds. The choices made can have significant financial consequences, influencing the amount of money received and when taxes must be paid.

Understanding the Annuity 5-Year Rule

The 5-Year Rule is a default distribution method established by the IRS for beneficiaries of non-qualified annuities. This regulation requires the beneficiary to withdraw the entire value of the annuity contract within five years following the original owner’s date of death. This rule generally applies when the annuity owner dies before the contract has been “annuitized,” which is the phase when the insurance company begins making regular payments to the owner.

The rule provides flexibility in how the withdrawals are made during the five-year window. A beneficiary can choose to take the entire amount as a single lump-sum payment, take periodic withdrawals at any time, or wait until the fifth year to withdraw the entire remaining balance. No distributions are mandated for any specific year before the final five-year deadline.

The 5-Year Rule often becomes the mandatory option if the beneficiary fails to elect a different payout method within a specific timeframe, typically 60 days to one year after the owner’s death. If no active choice is made, the five-year clock starts automatically. This rule applies to all non-spouse beneficiaries and is the only option for non-individual beneficiaries, such as trusts or charities.

Distribution Options for Non-Spouse Beneficiaries

A significant alternative to the 5-Year Rule is the “life expectancy” or “stretch” option. This method allows a non-spouse beneficiary to take distributions over their own life expectancy, as determined by IRS tables. To use this option, the beneficiary must begin taking distributions within one year of the owner’s death.

This approach creates a much longer potential payout period, allowing the remaining assets in the annuity to continue growing on a tax-deferred basis. Each year, the annual withdrawal amount is calculated by dividing the account balance from the end of the previous year by the beneficiary’s life expectancy factor. This provides a steady stream of payments that spreads the tax liability over many years.

A third choice is annuitization. With this option, the beneficiary uses the inherited death benefit to create a new stream of guaranteed income payments from the insurance company. These payments can be structured to last for the beneficiary’s entire life or for a specific period that does not exceed their life expectancy.

Special Provisions for Spouse Beneficiaries

A surviving spouse who inherits a non-qualified annuity has access to all the options available to a non-spouse beneficiary, plus a unique choice known as “spousal continuation.” This provision allows the surviving spouse to assume ownership of the annuity contract and treat it as their own. By electing spousal continuation, the spouse becomes the new owner of the contract and can even name their own beneficiaries.

This allows the annuity to continue growing tax-deferred, with no immediate distributions required. The surviving spouse can postpone withdrawals until after age 59½, avoiding an immediate taxable event. While a spouse can still choose the 5-Year Rule or take distributions over their life expectancy, spousal continuation is frequently the preferred path due to its significant tax deferral benefits.

Tax Implications of Inherited Annuity Distributions

The taxation of distributions from an inherited non-qualified annuity is consistent regardless of the payout method chosen. The tax liability is determined by separating the annuity’s value into two parts: the cost basis and the earnings. The cost basis represents the after-tax premiums paid into the contract by the original owner and can be withdrawn tax-free, while the earnings are subject to ordinary income tax.

Non-qualified annuities follow a Last-In, First-Out (LIFO) method for taxation. This means that for any withdrawal, the IRS considers the taxable earnings to be distributed first. Only after all of the earnings have been withdrawn and taxed can the beneficiary begin to access the tax-free cost basis.

For example, consider an inherited annuity valued at $150,000, with a cost basis of $100,000. This leaves $50,000 in taxable earnings. If the beneficiary takes a $20,000 distribution, the entire $20,000 will be taxed as ordinary income. Subsequent withdrawals will also be fully taxable until the entire $50,000 of earnings has been distributed.

Inherited non-qualified annuities do not receive a “step-up” in basis upon the owner’s death. The original cost basis carries over to the beneficiary, and all accumulated gains remain subject to taxation. This differs from other assets like stocks, where the cost basis is often adjusted to the market value at the time of death, potentially eliminating capital gains tax for the heir.