If you're the beneficiary of an annuity, you might be a little confused about the options that will be available to you, and understandably so.
When an annuity's owner passes away after naming a beneficiary to receive the remaining annuity funds, there may be choices that require careful consideration. Here's what you need to know to help make sure your annuity options work well for your financial situation.
What Kinds of Annuities Can Be Passed to a Beneficiary?
Not all annuities can be passed to a beneficiary. For example, an immediate annuity that provides regular payments may or may not include a benefit for a beneficiary.
Immediate Annuities
A life with period certain immediate annuity guarantees payments for a set period, often 10 or 20 years. Payments continue for the longer of the stated period or the life of the annuitant. If the annuitant dies before the period ends, the beneficiary receives the remaining payments.
Deferred Annuities
In most cases, the account value of a deferred annuity passes to a beneficiary when the owner dies.
Understanding Qualified & Non-Qualified Annuities
No matter whether the type of annuity is immediate or deferred, taxes work differently depending on how the annuity is funded. That is why it helps to know whether an annuity is qualified or non-qualified.
Qualified Annuities
Qualified annuities are funded with pre-tax dollars. A common example is a traditional IRA. Since taxes have not yet been paid on the money, the full amount a beneficiary receives is treated as taxable income.
Non-Qualified Annuities
Non-qualified annuities are funded with after tax dollars. This means only the earnings or growth are taxable. Contributions or premiums are not taxed again.
In some situations, including immediate annuities, annuitized payments, and certain stretch options, part of each payment is treated as a return of premium. That portion is not taxed. The remaining amount is considered earnings and is taxable. This calculation is known as the exclusion ratio.
Annuity Options for Beneficiaries
Immediate annuities do not always pass payments to a beneficiary, such as life-only options. Other contracts may include guaranteed payments. For deferred annuities, beneficiary claim options are outlined below, subject to the terms of the contract. These options may apply to qualified annuities, non-qualified annuities, or both.
- Five-Year Rule: Under this tax rule, the beneficiary must withdraw the entire annuity account value within five years of the owner’s death. Payments may be taken all at once, spread out over the five years, or in varying amounts, as long as the full balance is distributed before the deadline.
- Lump Sum: The beneficiary may choose to receive the full account value in a single payment.
- Stretch Option: This option allows beneficiaries to receive payments over their lifetime. Payment amounts are based on the beneficiary’s life expectancy and the annuity’s account value. This approach can spread out taxable gains while keeping funds in the annuity for potential continued growth.
- Rollover Into an Inherited IRA: Qualified annuity proceeds may be rolled into an inherited IRA, also called a beneficiary IRA. Taxes are deferred until distributions are taken, though required minimum distributions may apply depending on the deceased owner’s age.
- Spousal Continuation: A surviving spouse who is named as the sole beneficiary may be able to continue the annuity contract in their own name.
An annuity inheritance can be more complex than receiving cash, but it may provide added flexibility. Understanding your available options can help you make informed decisions that align with your financial goals.
Conclusion
Annuities can be passed to beneficiaries, but the available options and tax treatment depend on the type of annuity and how it was funded. Understanding whether an annuity is qualified or non-qualified, along with the distribution choices available, can help you manage taxes and timing more effectively. With the right knowledge, beneficiaries can choose an option that aligns with their financial needs and long-term goals.
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