It is important to have a thorough understanding of all the relevant concepts behind annuity contracts and how to maximise on them in order to successfully maximise its benefits especially upon inheriting one and becoming a beneficiary.
To begin, the following questions must be answered:
What is an inherited annuity?
An annuity contract is an investment established to secure financial assets and ensure their stability over a set time period/duration. It can also include a death benefit feature that designates a beneficiary to receive payments made by the annuitant—the person who established the annuity contract—following their (the annuitant’s) death. This is also known as an inherited annuity.
If the annuitant passes away before the term of the established annuity contract ends, the designated beneficiary will be receiving the annuity investment as an inheritance in the form of regular monthly, quarterly, or yearly payments. Designated annuity beneficiaries have several options when it comes to handling their inheritance.
However, beneficiaries should keep in mind that their options will largely be defined and determined by the nature of their relationship to the annuitant, the type of the annuity to be inherited, as well as the personal preferences and financial objectives of the beneficiary.
This is why it is important for beneficiaries to thoroughly understand the concepts behind inherited annuities and how they work since these will serve as guide to their decision-making process when it comes to managing their inherited annuities.
How does an inherited annuity work?
Beneficiaries could inherit either a qualified or a non-qualified annuity.
A qualified annuity is connected to retirement plans that include death benefit pensions and tax-exempt annuities, paid with a pre-tax amount. If the beneficiary is a spouse-beneficiary, they may consider moving all of the qualified annuity’s assets into another plan that is entirely exclusive to their own name.
However, if the beneficiary is not a spouse, the annuity payment will be received as a lump sum or beneficiaries could opt to create a separate individual retirement account (IRA) that will receive the annuity money after they inherit it.
A non-qualified annuity is a financial investment purchased beyond the auspices of an employment-related retirement plan using a post-tax amount.
Note that although the non-qualified annuity has already been subject to income tax, beneficiaries will still be required to pay a corresponding tax amount after any interest earned from the said amount upon withdrawal.
If beneficiaries inherit a non-qualified annuity, they will be required to pay taxes after the growth of the annuity amount.
What are the options in receiving disbursed payments from inherited annuities?
There are a number of ways and options in receiving disbursed payments from an annuity inheritance. These include the following:
Payment in lump sum
Upon the annuitant’s death, the beneficiary will receive the death benefit in full and as a one-time lump sum. The advantage of receiving a lump sum payment from inherited annuities allows beneficiaries the ability and flexibility to attend to their debt repayment obligations and handle larger expenditures.
Five-year receipt rule
This option requires the beneficiary to receive full distribution of the annuity inheritance money within five years of the annuitant’s death. This option also offers several sub-options for the beneficiary in the manner by which they will receive the annuity money. The beneficiary can:
- Take or receive portions of the overall amount in the course of the five-year period until the full annuity amount has been disbursed
- Take the total annuity amount by the fifth year, or
- Take the full annuity inheritance immediately upon the annuitant’s death
Note that the five-year rule is the only disbursement method/option available to trusts, estates and charities named as beneficiaries in an annuity contract.
Otherwise known as the life expectancy method, the non-qualified stretch option is regarded as one of the most effective alternatives in helping beneficiaries maximise on their annuity’s benefits. This is because the non-qualified stretch method allows beneficiaries to receive minimum disbursements in annual payments based on their life expectancy.
Beneficiaries are given power to decide on the schedule of payment disbursements, as well as name their own beneficiary or beneficiaries to receive the rest of the annuity amount in the event of their untimely death, before they have received full disbursement from the annuity inheritance.
This option allows beneficiaries to choose whether they receive a single-life or a term-certain annuity amount disbursement.
Single-life payouts are disbursed until the annuitant’s death; but in the case where there is still a remaining balance after death, the said amount will be surrendered to the insurance company.
Term-certain annuity payouts, on the other hand, observe a fixed period of time for disbursement. In this case, once the term has been completed, no payment shall be received by the annuitant or beneficiary, even if they are still alive.
Is inherited annuity taxable?
As briefly discussed above, taxation on inherited annuities depend on whether they are qualified or non-qualified annuities. Note, however, that inherited annuities in general have entailing tax implications. This is especially true when beneficiaries are not the spouse of the annuitant.
However, if the beneficiary is also the annuitant’s spouse, they may generally carry on with the original annuity contract without much concern on the annuity’s tax implications and the beneficiary’s obligations.
Non-spouse beneficiaries need to take into account several considerations. Ther inherited annuity’s taxes will largely depend on their disbursement choice. If a beneficiary chooses the lump sum payment option, they will have to attend to taxes on the growth of the original amount premium.
However, beneficiaries do not need to pay income tax on the said premium. If they have decided to carry on with the original annuity payment setup, individual taxation will be observed on each disbursement. This option will allow them to spread out tax liability over a more lengthened period.
What are the options when choosing to sell inherited annuities?
While some beneficiaries choose to carry on with the original annuity and receive monthly, quarterly, or yearly disbursements, some other inheriting beneficiaries choose to sell their annuities due to a variety of reasons; the most common ones include emergency expenditures, debt obligations and even university tuition.
For beneficiaries who choose to sell their inherited annuity, they may decide to do so in one of two options:
- Sale in part
- Sale in its entirety
Sale in part
Beneficiaries may sell a portion of each of their annuity disbursements, or sell a period of their payout. If the annuity disbursement lasts 10 years, they may consider selling years of their payments in exchange for a one-time pay or a lump sum. After involved term(s), beneficiaries may still continue receiving the remaining annuity balance. Another option is selling a portion of each annuity payout in exchange for a lump sum and then receiving succeeding smaller disbursements.
Sale in its entirety
Besides selling in part, other beneficiaries decide to sell their inherited annuities in their entirety instead. This option enables beneficiaries to sell their set continual disbursements through the annuity contract term, and in exchange for the said transaction, they will receive a one-time overall payment or lump sum.
Thoroughly understanding all the relevant concepts as well as the options available in handling inherited annuity or annuities will certainly help beneficiaries maximise on their benefits, as well as effectively prepare for tax implications. Do not hesitate to consult with a trusted accountant and/or lawyer with proven expertise on inherited annuities and all their legal, financial, and tax implications.