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 some 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 instance, an immediate annuity, which provides regular payments to the annuity's owner, may or may not guarantee funds to a beneficiary.
For instance, "life with period certain" immediate annuity payments provide a guaranteed number of payments, often for 10 or 20 years. This means the annuity's owner will receive payments either for 10 years or until the annuitant passes away — whichever is longer. If the annuitant dies before the end of the period, the beneficiary will receive the remaining payments. In addition, in most cases, the account value of a deferred annuity will pass to a beneficiary upon the death of the owner.
Understanding Qualified & Non-Qualified Annuities
Regardless of the type of annuity (immediate or deferred), it's important to understand potential tax consequences. That's why you need to determine if the annuity is qualified or non-qualified.
Qualified annuities are funded with pretax dollars. The most common example is a traditional IRA. This means the IRS has not yet taken any kind of tax cut from the money in a qualified annuity, so all of the money a beneficiary receives from such an annuity will be taxable income.
Non-qualified annuities are funded with after-tax dollars, which means that only the earnings or growth in these annuities are considered taxable — the contributions (or premiums) are not. In certain situations — including immediate annuities, annuitized payments and certain stretch options — the IRS treats part of each annuity payment as a "return of premium," meaning that part isn't subject to tax (this is also called the "exclusion ratio"). The rest of the withdrawal is treated as earnings, making that portion taxable.
Annuity Options for Beneficiaries
Immediate annuities do not always pass payments on to a beneficiary (such as life only), but others do (for example, they may guarantee certain payments). The claim options available for the beneficiary of a deferred annuity are generally as described below (subject to the terms of the contract).
Five-Year Rule — Under this tax law requirement, the beneficiary must take the distribution of the entire account value of the annuity within five years of the owner's death. The beneficiary can choose to take all of the proceeds at once, or spread the payment out over the five years, or anything in between — but the beneficiary must receive the entire account value before the five years are up.
Lump Sum — The beneficiary has the option of taking the entire account value of the annuity all at once.
Stretch Option — Beneficiaries may spread out receipt of the annuity's account value over their lifetime. The amount of money paid under the stretch option depends on the beneficiary's life expectancy and the account value of the annuity. This option can help spread out the taxation of gain and leave the bulk of the money in the annuity for potential continued growth.
Rollover Into an Inherited IRA — Qualified proceeds can be rolled over into an inherited IRA (or "beneficiary IRA"). This way, you can put off the tax burden until you've reached retirement and are taking distributions from the inherited IRA. However, a required minimum distribution (RMD) may be required based on the age of the deceased.
Spousal Continuation — Your surviving spouse may be able to continue the annuity contract if they are named as the sole beneficiary.
There are a number of reasons someone might want to make you a beneficiary of their annuity. Although this comes with more complexity than a straight cash inheritance might, it can also offer some flexibility — as long as you know your annuity options. Having the right information on hand can help you make the best decisions.