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What are your options if you inherit an annuity? Annuities are financial products that are paid for upfront, then pay out a set amount for a period of time, sometimes until death. They are sometimes used by retirees to secure a reliable income in retirement. Some annuities payments can be left to a beneficiary after death if money remains.
Options for the Surviving Spouse
Distribution options will vary depending on if you are the surviving spouse or someone other than the surviving spouse. If you are the surviving spouse, you have several options, but the most common is to treat the annuity as your own, keeping all the options the owner had.
Annuities can be structured in a wide variety of ways, so options will vary on the particular annuity structure negotiated with the annuity provider at the time of the sale. Some options include whether or not to include the spouse as a beneficiary, when to begin payments, and how long the payment stream will continue.
Options for People Who Are Not the Surviving Spouse
As someone other than the surviving spouse, you will basically have three potential options:
a) Lump-sum payout
b) Full payout over the next five years
c) Elect within 60 days to annuitize over your own lifetime
If the annuity payments have already begun, you must take the payments at least as rapidly as the original owner was taking them. The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase.
When a person inherits an annuity, the gains stay with the policy. Depending on the type of annuity, the tax will have to be paid on the lump sum received or on the regular fixed payments. The payments received from an annuity are treated as ordinary income, which could be as high as a 37% marginal tax rate depending on your tax bracket.
Supposing that this annuity was purchased with after-tax dollars, ordinary income is owed on all gains but not on the earned principal. A portion of each annuity payment will be considered a tax-free return of principal, spreading the tax liability out over time, unless you select the lump-sum payout.
Lump-Sum Distributions
A lump-sum distribution is a one-time payout of a plan, instead of having the payout broken into several smaller payouts made over time. Lump-sum payments can have tax implications. The Internal Revenue Service provides guides to help understand the tax implications of lump-sum payouts. According to the IRS:
A lump-sum distribution is a distribution that’s paid:
- Because of the plan participant’s death
- After the participant reaches age 59½
- Because the participant, if an employee, separates from service, or
- After the participant, if a self-employed individual, becomes totally and permanently disabled
Tax obligations may possibly be deferred by rolling the lump-sum distribution over into an individual retirement account. According to the IRS: “You should receive a Form 1099-R from the payer of the lump-sum distribution showing your taxable distribution and the amount eligible for capital gain treatment. If your Form 1099-R isn’t made available to you by January 31 of the year following the year of the distribution, you should contact the payer of your lump-sum distribution.”