What Is the Best Thing to Do With an Inherited Annuity?

An inherited annuity represents the remaining value of an annuity contract that is passed to a designated beneficiary upon the original owner’s death. Understanding the various choices available to beneficiaries and the tax implications of these choices becomes important for managing the inherited funds effectively.

Key Characteristics of Inherited Annuities

An inherited annuity differs significantly from an annuity held by its original owner, primarily concerning tax treatment and distribution rules.

The distinction between “qualified” and “non-qualified” inherited annuities is important in determining how these assets are taxed and distributed. Qualified annuities are funded with pre-tax dollars, often held within tax-advantaged retirement accounts such as an Individual Retirement Account (IRA) or a 401(k). Distributions from qualified annuities are fully taxable as ordinary income because the original contributions were never taxed.

In contrast, non-qualified annuities are purchased with after-tax money, meaning the principal contributions have already been taxed. When a non-qualified annuity is inherited, only the earnings or growth portion of the annuity is subject to taxation as ordinary income. The original after-tax contributions are not taxed again upon withdrawal.

The original owner’s death triggers the application of specific beneficiary rules, which vary based on the relationship of the beneficiary to the deceased owner and the type of annuity. Annuities are tax-deferred, meaning taxes on earnings are only incurred when payments are received. How a beneficiary chooses to receive the death benefit directly influences the tax implications and the timing of those taxes.

Options for Spousal Beneficiaries

Surviving spouses who inherit an annuity have more flexible options compared to other beneficiaries. One common choice is “spousal continuation,” which allows the surviving spouse to assume ownership of the annuity contract as if they were the original owner. This option permits the spouse to continue the annuity’s tax-deferred growth without immediate tax consequences. The surviving spouse can take over the payments or continue deferring them according to the original contract terms.

Another option for a surviving spouse is a “spousal rollover,” particularly for qualified annuities. A surviving spouse can roll over the inherited qualified annuity into their own IRA or other qualified retirement account. This strategy maintains the tax-deferred status of the funds, delaying taxation until distributions are taken from their own retirement account. The spouse gains control over future distributions, aligning them with their own retirement planning needs.

For non-qualified annuities, a spouse may also have the option to continue receiving payments over their life expectancy, spreading out the tax liability on the earnings over a longer period. The choice between continuation and rollover for a qualified annuity depends on the spouse’s financial situation and immediate need for funds.

Options for Non-Spousal Beneficiaries

Non-spousal beneficiaries, such as children, siblings, or trusts, face different rules and tax implications when inheriting an annuity. One immediate choice is to take a “lump sum distribution,” where the entire annuity value is received in one payment. While this provides immediate access to funds, it can lead to significant tax consequences, as the entire taxable portion (growth for non-qualified, full amount for qualified) is taxed as ordinary income in the year of receipt. This immediate taxation can potentially push the beneficiary into a higher tax bracket.

Another approach is to elect “annuitization,” receiving payments over a specified period or the beneficiary’s life expectancy. This method, often referred to as a “stretch provision,” spreads out the tax liability over multiple years, as only a portion of each payment is considered taxable income. This option is available to “eligible designated beneficiaries” under the SECURE Act. The Internal Revenue Service (IRS) taxes the growth portion of each payment first for non-qualified annuities, which means the initial payments will have a higher taxable component.

The “10-Year Rule” introduced by the SECURE Act impacts non-spousal beneficiaries of annuities inherited from owners who died on or after January 1, 2020. Under this rule, the entire inherited annuity value must be distributed by the end of the tenth calendar year following the original owner’s death. Annual distributions are not mandated during this period, offering flexibility in timing withdrawals, but the full balance must be withdrawn by the deadline. This rule primarily applies to qualified annuities held within inherited IRAs.

For annuities inherited from owners who died before January 1, 2020, the “5-Year Rule” applies. This rule requires the entire value of the inherited annuity to be distributed within five years of the original owner’s death, with no required annual distributions. Non-qualified annuities fall under this five-year distribution period for non-spousal beneficiaries.