What Is the Inherited Annuity 10-Year Rule?

An inherited annuity is a contract with an insurance company passed down to a beneficiary upon the original owner’s death. The rules governing how a beneficiary can access these funds have undergone significant changes, altering the financial planning landscape for many who inherit such assets. Beneficiaries must navigate a series of regulations to access the annuity’s value. The timing and method of distributions can have considerable financial consequences, making it necessary for beneficiaries to be well-informed about their options.

The Foundation of the 10-Year Rule

The framework for the 10-year rule was established by the Setting Every Community Up for Retirement Enhancement (SECURE) Act, effective January 1, 2020. The rule mandates that for most non-spouse beneficiaries, the entire balance of the inherited account must be withdrawn by the end of the tenth calendar year following the year of the original owner’s death. To illustrate, if an annuity owner passed away in 2023, the beneficiary has until December 31, 2033, to liquidate the account.

This rule replaced the previous “stretch” provision for many beneficiaries, which had allowed them to take distributions over their own life expectancy. The primary impact is the compression of the withdrawal period, which can have significant tax implications. Any funds remaining in the account after the 10-year deadline are subject to a 25% penalty, which can be reduced to 10% if the shortfall is corrected in a timely manner.

Identifying the Correct Beneficiary Category

The applicable distribution rules for an inherited annuity depend on the beneficiary’s specific category. The regulations differ based on the beneficiary’s relationship to the original owner and other criteria, which dictates whether the 10-year rule or other options are available.

Spousal Beneficiaries

A surviving spouse who is the sole beneficiary of an annuity has flexible options. The most advantageous choice is spousal continuation, where the spouse can treat the inherited annuity as their own. This allows the contract to continue under the surviving spouse’s ownership, preserving its tax-deferred status and avoiding immediate tax consequences.

Eligible Designated Beneficiaries (EDBs)

The SECURE Act created a special category known as Eligible Designated Beneficiaries (EDBs). This group is exempt from the 10-year rule and can take distributions over their life expectancy, similar to the old “stretch” rules. EDBs include:

• The surviving spouse
• Minor children of the original account owner
• Disabled or chronically ill individuals, as defined by the IRS
• Beneficiaries who are not more than 10 years younger than the deceased owner

For minor children of the original owner, the 10-year rule begins once they reach age 21.

Non-Eligible Designated Beneficiaries

Most non-spouse individual beneficiaries, such as adult children, grandchildren, siblings, or friends, fall into the category of Non-Eligible Designated Beneficiaries. This is the primary group subject to the 10-year rule, which requires them to withdraw the entire inherited annuity balance within the ten-year timeframe.

Non-Designated Beneficiaries

The final category is non-designated beneficiaries, which includes entities such as estates, most types of trusts, and charities. If the annuity owner died before their required beginning date for distributions, a non-designated beneficiary must withdraw the entire account balance within five years.

Distribution Methods Under the 10-Year Rule

For a Non-Eligible Designated Beneficiary, the 10-year rule provides a fixed window to withdraw all funds but allows for flexibility within that period. A beneficiary is not required to take withdrawals on a specific schedule, as long as the account is fully depleted by the deadline. This flexibility leads to two primary strategies for managing the distributions.

The first approach is a lump-sum distribution, where a beneficiary withdraws the entire account balance at once. While simple, this method can result in a significant, one-time tax liability, as the entire taxable portion of the annuity is recognized as income in a single year, potentially pushing the beneficiary into a higher tax bracket.

Alternatively, a beneficiary can take periodic withdrawals. This strategy allows for distributions of any amount at any frequency, offering control over the timing and size of the income received. This method provides an opportunity to manage the tax impact by spreading the income over several years.

A consideration is whether annual Required Minimum Distributions (RMDs) are necessary during the 10-year period. If the owner died before their Required Beginning Date, the beneficiary is not required to take any distributions until the final year of the 10-year period. However, if the owner died on or after their Required Beginning Date, the beneficiary must take annual RMDs in years one through nine, in addition to emptying the account by the end of the tenth year. The IRS relief for missed annual RMDs ended in 2024.

Taxation of Inherited Annuity Payouts

The tax treatment of distributions from an inherited annuity depends on whether the annuity is classified as qualified or non-qualified. This distinction is based on the type of funds used to purchase the original contract.

Qualified Annuities

A qualified annuity is funded with pre-tax dollars, typically within a retirement plan like a 401(k) or a Traditional IRA. Because the contributions were not taxed, all distributions from a qualified annuity are fully taxable as ordinary income to the beneficiary. When a beneficiary takes a withdrawal, the entire amount received is added to their gross income for that year and taxed at their marginal income tax rate.

Non-Qualified Annuities

A non-qualified annuity is purchased with after-tax dollars, meaning the original owner already paid income tax on the premiums. Consequently, only the earnings portion of the annuity is subject to taxation upon withdrawal. The portion of each distribution that represents a return of the original premium payments is received tax-free, which is managed through an “exclusion ratio.”

For example, if the original owner paid $60,000 in premiums and the annuity’s value at inheritance is $100,000, the earnings are $40,000. If the beneficiary takes a lump-sum distribution, they would pay ordinary income tax on the $40,000 of earnings. If they take periodic payments, a portion of each payment would be considered a tax-free return of premium and the remainder would be taxable earnings.