What to Do With an Inherited Annuity: Your Options

When an individual passes away, their assets, including annuities, often transfer to designated beneficiaries. An inherited annuity is a financial product that allows the beneficiary of an annuity contract to receive payments after the original owner’s death. Understanding the available options and their potential consequences is important for beneficiaries navigating this process.

Understanding Your Inherited Annuity

Identifying the specific type of annuity inherited is an important step, as it influences available distribution options and tax treatment. Annuities are broadly categorized as either qualified or non-qualified. Qualified annuities are funded with pre-tax dollars within retirement accounts, such as IRAs or 401(k)s. Distributions from these annuities are fully taxable as ordinary income because the original contributions were made on a pre-tax basis.

Non-qualified annuities are purchased with after-tax dollars. For these annuities, only the earnings portion of distributions is subject to taxation, while the original principal is returned tax-free. Annuities can also be classified as immediate, which begin paying out right away, or deferred, which allow payments to start at a future date. The distinction between qualified and non-qualified is significant for tax planning.

Determining your beneficiary status is another important factor, as this dictates the specific rules you must follow. Beneficiaries are categorized as a spouse, a non-spouse designated beneficiary, or a non-designated beneficiary, such as an estate or trust. Spousal beneficiaries have the most flexibility, while non-spouse designated beneficiaries are subject to different rules. Entities like trusts or estates face distinct distribution requirements.

To begin the process, gather information about the inherited annuity. This includes locating the original annuity contract, which contains details about the policy terms, death benefits, and designated beneficiaries. Obtaining a certified copy of the original owner’s death certificate is also necessary. Contacting the annuity provider directly will allow you to confirm the contract’s current value, any remaining guarantees, and, for non-qualified annuities, the original owner’s cost basis. This information is important for making informed decisions regarding distribution options and understanding the tax consequences.

Distribution Options for Beneficiaries

Beneficiaries of an inherited annuity have several choices regarding how to receive the funds, dependent on their relationship to the original owner and the annuity’s type. A common choice for all beneficiary types is a lump sum distribution, where the entire value of the annuity is paid out at once. This option provides immediate access to the funds but can have significant tax implications, as all taxable earnings are recognized in a single tax year.

For a spousal beneficiary, the options are the most flexible. A surviving spouse can choose spousal continuation, treating the inherited annuity as their own contract. This allows for continued tax-deferred growth and the ability to defer distributions until required for the spouse. Alternatively, a spouse can elect to take distributions over their lifetime, providing a steady income stream, or receive a lump sum payment.

Non-spousal designated beneficiaries are subject to rules influenced by the SECURE Act. For most non-spousal designated beneficiaries, this legislation introduced the 10-year rule. Under this rule, the entire inherited annuity balance must be distributed by the end of the tenth year following the original owner’s death. While annual required minimum distributions (RMDs) are not mandated during this 10-year period, the full amount must be withdrawn and taxed by the deadline.

There are exceptions to the 10-year rule for “eligible designated beneficiaries” who can stretch payments over their life expectancy. This group includes minor children of the original owner, individuals who are disabled or chronically ill, and beneficiaries who are not more than 10 years younger than the annuitant. These beneficiaries can elect to receive distributions over their life expectancy, allowing for a more gradual payout and potentially spreading out the tax liability over a longer period.

For non-designated beneficiaries, such as an estate or a trust, the rules can be more restrictive. Often, these beneficiaries are subject to a 5-year rule. This rule requires the entire annuity balance to be distributed within five years of the original owner’s death. Similar to the 10-year rule, the 5-year rule does not impose annual RMDs, but the full value must be withdrawn by the end of the fifth year. The annuity contract and the type of entity named as beneficiary will determine the distribution requirements.

Tax Implications of Distributions

Understanding the tax implications is an important consideration when deciding how to receive an inherited annuity. Earnings from annuities are taxed as ordinary income upon distribution. This means the income is added to your other taxable income for the year and is subject to your marginal income tax rate.

The tax treatment differs between qualified and non-qualified annuities. For qualified annuities, funded with pre-tax dollars, the entire distribution, including both contributions and earnings, is considered taxable income. In contrast, with non-qualified annuities, only the earnings portion is taxable, because the original contributions were made with after-tax money and are returned tax-free. The original cost basis, representing the after-tax contributions, is not subject to further taxation.

The chosen distribution option directly impacts the tax consequences. Taking a lump sum distribution can result in a significant tax bill for that year, potentially pushing the beneficiary into a higher income tax bracket. This is because all accumulated taxable earnings are recognized in a single tax year. Conversely, options that allow for payments to be stretched over a longer period, such as life expectancy payments or the 10-year rule, can help spread out the tax liability over multiple years. This strategy can mitigate the impact of taxation by keeping distributions within lower tax brackets over time.

For non-qualified annuities, when payments are stretched, the Internal Revenue Service (IRS) considers earnings to be distributed first for tax purposes. This means the taxable portion of the annuity is paid out before the tax-free return of principal. A note for beneficiaries is that the 10% early withdrawal penalty, which applies to withdrawals from annuities before age 59½, does not apply to inherited annuities. This exemption is due to the distribution being a result of the owner’s death, regardless of the beneficiary’s age.

Initiating the Distribution Process

Once you have determined the distribution strategy for your inherited annuity, the next step involves initiating the distribution process with the annuity provider. Begin by contacting the annuity company directly. Many providers have beneficiary services departments to guide you. You can find their contact information on the annuity contract or their official website.

The annuity provider will require documentation to process your claim. Required documentation includes a certified copy of the original annuity owner’s death certificate, a completed beneficiary claim form provided by the company, and proof of your identity, such as a government-issued identification. Ensure all forms are accurately completed and signed as required.

After gathering the documents and completing the forms, submit them to the annuity provider. Submission methods include mailing the documents, uploading them through an online portal, or submitting them in person at a local office. After submission, the provider will confirm receipt of your paperwork. They will then process your request, which can take several weeks. You will be informed when distributions are expected to begin, in accordance with your chosen payout option.