Inherited Annuity: Definition, Benefits and Rules

Inheriting an annuity from a spouse, parent, or someone else, could provide you with a financial windfall. If you stand to inherit an annuity, it helps to understand the different options you have for receiving it and how distributions may be taxed.

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How an annuity works

An annuity is an insurance contract that provides payments to an annuitant. The annuitant is typically also the annuity owner or the person who purchases the contract.

Annuities can provide a supplemental stream of income in retirement, either for a definite time period or for life. There are several types of annuities to choose from, including:

• Fixed annuities, which pay a fixed amount to the annuitant.
• Variable annuities, which make payments based on the performance of an underlying stock market index.
• Joint and survivor annuities, which are designed to allow one spouse to pass benefits on to another.

Inherited annuities provide a death benefit for one or more named beneficiaries. For instance, you might purchase an annuity and name your spouse or adult children as beneficiaries. When you pass away, your beneficiaries will inherit the annuity and any payments remaining in the contract from you.

If you're poised to inherit an annuity, it's important to understand the potential tax implications and your options for receiving any payments due to you.

Inherited annuity options

The type of contract that was established determines how an annuity can be paid out to a beneficiary. Generally speaking, there are three ways to categorize inherited annuities when determining tax liability.

Qualified

A qualified annuity is funded with pre-tax dollars and may be purchased through a tax-advantaged retirement plan, such as a traditional 401(k) or IRA. When funds are withdrawn from a qualified annuity, the principal and earnings are subject to ordinary income tax.

This applies to the original annuitant and any beneficiaries who inherit an annuity. If you inherit a qualified annuity, any money you receive would be subject to tax. However, surviving spouses may be able to defer payment of any taxes due.

Inherited qualified annuities are subject to required minimum distribution (RMD) rules. RMDs are the minimum amounts you must withdraw based on life expectancy. Distributions must begin at age 73 to avoid a steep tax penalty.

Non-qualified

Non-qualified annuities are funded with after-tax dollars. When the annuitant receives payments from a non-qualified annuity, only the earnings are subject to income tax.

Inheriting a non-qualified annuity may lessen your tax burden to a degree since withdrawals from the principal are not taxed. Non-qualified annuities are not subject to RMD rules either, so you don't have to worry about triggering a tax penalty for failing to take them on time.

Surviving spouse

A surviving spouse who inherits an annuity may be able to assume ownership of the contract through a continuance. In doing so, they would be able to collect payments according to the terms of the original contract and potentially put off having to pay taxes on distributions.

This option is available with both qualified and non-qualified annuities. Choosing a spousal continuance can allow for more efficient tax treatment of payments over the surviving spouse's life expectancy. Of course, spouses can also opt for an immediate lump-sum distribution of the entire amount.

Inherited annuity rules for people other than surviving spouses

If you inherit an annuity from someone other than a spouse, you don't have the option to assume ownership of the contract through a continuance. Instead, you would generally have to choose from one of these options:

• Withdraw the entirety of the annuity in a lump sum.
• Apply the 10-year rule for taking distributions.
• Annuitize payments over your lifetime.

You could take a lump-sum distribution if you need or want to receive all of the money from an annuity in one go. However, the SECURE Act allows you to withdraw an inherited annuity up to the 10th year following the annuity owner's death.

Tip: Some annuities may adhere to the older 5-year rule, which existed prior to the passage of the SECURE Act, so it's important to fully understand the terms of the contract.

You might choose to annuitize payments from an inherited annuity if you prefer to receive a continuous income stream. This option is available with non-qualified annuities and may yield the most favorable tax treatment, depending on your life expectancy.

Annuity death benefits

Annuities can offer several different types of death benefits. The type of death benefit a contract includes may depend on the insurer.

Here are the options:

• Standard death benefit: Pays out an amount equal to the current contract value to the beneficiary.
• Return of premium: Pays a benefit equal to the account value or initial premiums paid, whichever is greater.
• Stepped-up benefit: Pays out a benefit equal to the current account value or a historical peak value, whichever is greater.
• Guaranteed increase: Adds a percentage of value to the initial investment each year. The contract then pays out either the actual account value or the initial investment with the annual add-on, whichever is greater.

Regardless of which type of death benefit someone inherits, the same tax rules for qualified vs. non-qualified annuities and the same withdrawal rules for spousal vs. non-spousal beneficiaries apply.

What can you do with an inherited annuity?

The first thing you'll need to consider with an inherited annuity is how to withdraw it. Again, if you're a surviving spouse, you might be able to transfer the contract to yourself as the new owner. If not, you can withdraw it as a lump sum, spread payments out over 10 years, or consider annuitization based on your life expectancy.

How you choose to withdraw an annuity can determine what you end up doing with the money. Some of the ways that you might put an inherited annuity to work include:

• Trading it for another annuity through a 1035 exchange.
• Rolling it into an inherited IRA (if you're a surviving spouse).
• Use it to fund a traditional or Roth IRA in your name.
• Paying off your mortgage or other debts.
• Covering higher education expenses for one of your children.
• Managing long-term care expenses as you get older.

As you can see, you have options when inheriting an annuity, but remember that taxes can directly impact how much you can collect.

What are lump-sum distributions?

Taking a lump-sum distribution from an annuity simply means that you choose to receive all of the payments owed to you at once. That option is available with both qualified and non-qualified annuities.

Why would you choose a lump-sum distribution from an inherited annuity? You might prefer this option if you need cash immediately and are comfortable with paying the taxes due on the distribution right away. For instance, if you need cash for a major home repair, you may choose to use an annuity inheritance to cover it rather than borrowing against your home equity or taking out a personal loan.

However, if you don't need all of the money now, there may be better options for drawing down an inherited annuity. After all, lump-sum distributions could temporarily push you into a much higher tax bracket if you expect to receive a sizable amount from the annuity contract.

Featured partner

J.P. Morgan Personal Advisors

View Offer

Featured partner

J.P. Morgan Personal Advisors

Fees

0.50%-0.60% based on portfolio size

Minimum investment

$25,000

Assets under management

$4.3 million

Financial planning

Education, home purchase, retirement, travel and more

Disclosures:

INVESTMENT AND INSURANCE PRODUCTS ARE: NOT A DEPOSIT • NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE

J.P. Morgan Wealth Management is a business of JPMorgan Chase & Co., which offers investment products and services through J.P. Morgan Securities LLC (“J.P. Morgan”), a registered broker dealer and investment adviser, member FINRA and SIPC. TIME Stamped is a publisher of J.P. Morgan, (“Publisher”). The Publisher will receive compensation from J.P. Morgan if you provide contact details to speak with a J.P. Morgan representative. Compensation paid to the Publisher will be up to $500 per completed contact form. Compensation provides an incentive for the Publisher to endorse J.P. Morgan and therefore information, opinions, or referrals are subject to bias. J.P. Morgan and the Publisher are not under common ownership or otherwise related entities, and each are responsible for their own obligations. Investing involves market risk, including possible loss of principal, and there is no guarantee that investment objectives will be achieved.

What are the tax implications of an inherited annuity?

If you inherit an annuity, the amount you'll owe in taxes will depend on the type of annuity, whether you're a spousal or non-spousal beneficiary, and how you choose to withdraw.

The most important distinctions to remember are as follows:

• Qualified annuities are subject to income tax on both principal and earnings.
• With non-qualified annuities, only earnings are subject to tax.
• Qualified annuities require RMDs while non-qualified annuities do not.

Remember that ordinary income tax rates apply to inherited annuity withdrawals. If you're in a higher tax bracket, you could pay more in taxes overall, regardless of how you choose to withdraw an inherited annuity.

How to mitigate the tax burden of inherited annuities

While you can't completely avoid paying taxes on an inherited annuity, there are some strategies you can use to lessen your tax burden.

For instance, that might include:

• Taking a spousal continuance to defer payments and associated taxes.
• Rolling it into a new deferred annuity if you're eligible to do so.
• Using a 1035 exchange to swap out one annuity for another to defer taxes.

The tax rules for annuities can be confusing, so we recommend that you consult a financial advisor or tax professional for advice on managing an inherited annuity to minimize taxes.

Also, you might find it helpful to use an online tool to manage your annuity funds. Empower and Retirable are two online platforms designed to help you stay on top of your finances. Both allow you to create automated plans for saving and investing so that you're better equipped to reach your financial goals. Comparing the features and fees can help you decide if either one might be right for you.

TIME Stamp: Know your options when inheriting an annuity

Receiving an annuity inheritance can complicate your financial plan if you're unprepared for it. Learning how annuities work and what happens when you inherit one can keep you from being caught off-guard during what may already be an emotionally trying time.

Frequently asked questions (FAQs)

What is the primary rule for an inherited annuity?

The main rule to know for inherited annuities centers on tax treatment and whether an annuity is qualified or non-qualified. Qualified annuities are taxed on both principal and earnings, while non-qualified annuities are taxed on earnings only.

Can you cash out an inherited annuity?

You could cash out an inherited annuity by taking a lump-sum distribution. That would allow you to withdraw the principal and earnings all at once, though it could leave you facing a large tax bill if you're pushed into a higher tax bracket.

Who is the beneficiary of an inherited annuity?

The beneficiary of an inherited annuity is the person or persons named by the annuity owner. That may be a surviving spouse, an adult child, a minor child, or someone else. Beneficiaries are entitled to receive benefits from an annuity once the original owner passes away.

How much does a $50,000 annuity pay monthly?

The amount that a $50,000 annuity will pay monthly will depend on whether it's a fixed or variable annuity and the time frame in which payments are scheduled to be made. The longer the period in which payments are made, the lower those monthly payments will typically be.