Inherited Annuity: Understanding Rules, Taxes, and Payout Options

When thinking about inheritance, people often picture property, cash, or family heirlooms. However, annuities—a key estate-planning tool—are often overlooked. An annuity is a financial contract with an insurance company designed to provide a steady income stream, typically during retirement. Upon the original owner’s passing, the annuity is transferred to a designated beneficiary, triggering unique rules and tax implications.

Beneficiaries receiving an inherited annuity must navigate complex payout rules, potential tax liabilities, and specific inheritance regulations. Depending on the annuity’s structure—whether qualified (pre-tax contributions) or non-qualified (after-tax contributions)—different tax treatments apply. Understanding these critical details helps avoid common pitfalls while maximizing the financial benefit of an inherited annuity.

Inherited annuity rules differ based on the beneficiary's relationship to the original owner. The IRS divides beneficiaries into two categories: spousal beneficiaries and non-spousal beneficiaries, each with unique inheritance options and tax considerations.

Spousal vs. Non-Spousal Annuity Inheritance

Spousal Beneficiaries

Spouses benefit from the most flexible rules when inheriting an annuity. The IRS allows spouses to either continue the original contract or create a new annuity under their name. Key options include:

• Assume Ownership:
  Spouses can take over the annuity as the new owner, continuing tax-deferred growth and delaying Required Minimum Distributions (RMDs) until they reach the appropriate age.
• Annuitize the Contract:
  If income is needed, spouses can select a payout plan and receive structured payments based on the contract terms, spreading tax obligations over time.
• Lump-Sum Payment:
  Spouses may withdraw the full balance at once. While this provides immediate liquidity, it creates a significant taxable event in the withdrawal year.

Non-Spousal Beneficiaries

Non-spousal beneficiaries face more restrictive payout rules and must choose from several distribution options:

• Lump-Sum Distribution:
  The entire balance is withdrawn at once, fully taxable as ordinary income, often leading to a higher tax bill.
• Five-Year Rule:
  Funds must be withdrawn within five years of the original owner’s passing. Withdrawals can be made at any time, allowing beneficiaries to manage tax liabilities strategically.
• Life Expectancy Payouts:
  This option spreads distributions over the beneficiary’s expected lifespan, helping reduce annual tax burdens while providing a predictable income stream.

The SECURE Act of 2019 reshaped the rules governing inherited annuities, particularly for tax-deferred accounts like IRAs. Major changes include:

• 10-Year Rule for Non-Spousal Beneficiaries:
  Non-spouses must withdraw the entire annuity balance within ten years, accelerating taxes owed and limiting long-term tax deferral.
• Elimination of Stretch IRAs:
  Previously, beneficiaries could stretch payments over their lifetimes. This provision was eliminated for most non-spousal accounts, creating a compressed withdrawal timeline.
• New RMD Rules:
  Required Minimum Distributions still apply to certain inherited annuities, forcing annual withdrawals based on IRS life expectancy tables.

Understanding the tax implications of an inherited annuity is critical for beneficiaries. Tax treatment depends on the annuity’s type, payout selection, and the original owner’s contribution structure.

Annuity Tax Exclusion Ratio Explained

The tax exclusion ratio determines the taxable and non-taxable portions of each annuity payment. Payments are divided into two components:

• Tax-Free Portion: Represents the original after-tax investment made by the annuity owner. This portion is not taxed again.
• Taxable Portion: Includes all gains, earnings, and accumulated interest, taxed as ordinary income upon distribution.

Example:
If the original investment was $100,000 and the annuity’s value grew to $150,000, only $50,000 would be taxable as income. Payments are split proportionally based on this ratio, reducing taxable income annually.

Inherited Annuity Income Tax Considerations

Since annuities don’t receive a step-up in cost basis, beneficiaries must be prepared for tax liabilities. Consider these tax management strategies:

• Avoid Large Lump-Sum Withdrawals:
  Taking the full balance in one year can push beneficiaries into a higher tax bracket, resulting in steep taxes.
• Spread Distributions Over Time:
  Use life expectancy payouts or the five-year rule to reduce annual tax burdens.
• Understand Qualified vs. Non-Qualified Taxation:
  Qualified annuities are fully taxable, while non-qualified annuities offer partial tax exclusion through the exclusion ratio.

When inheriting an annuity, choosing the right payout option is essential for maximizing financial benefits and minimizing tax liabilities. The IRS provides several payout methods based on the annuity contract, the type of annuity (qualified or non-qualified), and the relationship between the beneficiary and the original owner. Each option has unique advantages, potential drawbacks, and tax implications. Here’s a comprehensive breakdown of the most common annuity payout options:

A lump-sum annuity distribution allows beneficiaries to withdraw the entire annuity balance in one payment. This option provides immediate access to funds but comes with tax consequences. Any earnings or gains within the annuity are taxed as ordinary income in the year of withdrawal, potentially pushing the beneficiary into a higher tax bracket.

Best For:

• Beneficiaries needing immediate cash for major expenses, such as paying off debt, funding a business, or purchasing property.
• Those without long-term financial stability concerns who prefer flexibility.

Considerations:

• Higher Tax Liability: Because the entire annuity payout is taxable as income, beneficiaries could face a steep tax bill.
• Loss of Tax-Deferred Growth: Withdrawing all funds ends the annuity's tax-deferred growth potential, forfeiting long-term financial benefits.
• Risk of Over-Spending: Receiving a large sum at once can lead to poor financial decisions if funds aren’t carefully managed.

Example:
If a non-spousal beneficiary inherits a $200,000 annuity with $50,000 in taxable growth, the full $50,000 would be taxed as ordinary income in the withdrawal year, potentially increasing the tax burden considerably.

The Five-Year Rule gives beneficiaries flexibility by allowing withdrawals over a five-year period. The full annuity balance must be distributed by the end of the fifth year following the original owner’s death, regardless of when withdrawals begin. This option helps spread out taxable income, offering some level of tax planning.

Advantages:

• Flexible Timing: Beneficiaries can choose when and how much to withdraw, giving control over annual taxable income.
• Tax Management: Strategically timed withdrawals can help avoid being pushed into a higher tax bracket.
• Avoids Lump-Sum Tax Shock: Spreading withdrawals reduces the likelihood of a large single-year tax bill.

Drawbacks:

• Deadline Pressure: The five-year withdrawal period cannot be extended, forcing full distribution even if the market conditions are unfavorable.
• Potential Tax Spike: If beneficiaries wait until the fifth year to withdraw the full amount, the entire balance is taxed at once.

Example:
Suppose a beneficiary inherits a $300,000 annuity. They can withdraw $60,000 annually over five years, reducing their taxable income each year. However, if they fail to withdraw funds by the fifth year, the IRS imposes penalties and requires the full distribution.

Life Expectancy Payouts, also called the “Stretch Option”, allow beneficiaries to spread withdrawals over their remaining life expectancy, as determined by IRS life expectancy tables. This option minimizes yearly tax liabilities by reducing the amount of taxable income received each year while ensuring long-term financial stability.

Best For:

• Younger beneficiaries looking for long-term income.
• Those wanting predictable, steady cash flow over time.

Advantages:

• Reduced Annual Taxes: Since withdrawals are spread across the beneficiary's lifespan, annual tax obligations are lower.
• Consistent Income Stream: This payout option provides regular payments, ensuring a steady income for long-term financial security.
• Maximizes Tax Deferral: Stretching payments keeps funds growing tax-deferred within the annuity.

Drawbacks:

• IRS Withdrawal Rules: Beneficiaries must withdraw at least the Required Minimum Distribution (RMD) amount yearly, as determined by IRS life expectancy tables.
• Investment Risk: If the annuity is linked to market performance, payout amounts may fluctuate.

Example:
If a 40-year-old beneficiary inherits a $500,000 annuity, they might receive annual payments based on a life expectancy of 43.6 years, as determined by IRS tables. This strategy minimizes their yearly taxable income and ensures a consistent retirement income stream.

Annuitization involves converting the annuity into a fixed stream of income payments over a specified period or the beneficiary’s lifetime. This method offers predictable income while ensuring beneficiaries receive steady payments.

Best For:

• Beneficiaries seeking guaranteed lifetime income.
• Those who prefer predictable cash flow and simplified financial management.

Annuitization Types:

• Fixed Period Payments: Payments continue for a set number of years. If the beneficiary dies before the period ends, remaining payments go to a contingent beneficiary.
• Lifetime Payments: Payments continue for the beneficiary's entire lifetime, reducing longevity risk (the risk of outliving one’s savings).

Considerations:

• Irrevocable Choice: Once annuitization is selected, the decision cannot be reversed.
• No Control Over Principal: Unlike the five-year or lump-sum payout options, beneficiaries cannot withdraw extra funds from the annuity.

Example:
A 55-year-old beneficiary who chooses lifetime annuitization might receive fixed monthly payments of $2,000 for the rest of their life, regardless of the annuity’s market performance.

Though not technically a “payout” option, 1035 Exchanges allow annuity holders to transfer the value of an inherited annuity into another annuity product, preserving tax-deferred growth while gaining better contract terms or investment features.

Best For:

• Beneficiaries wanting to upgrade an annuity’s investment potential.
• Spouses wishing to transfer funds into a more suitable policy.

Example:
A spousal beneficiary may exchange a fixed annuity for a variable or indexed annuity, taking advantage of better investment returns while deferring tax obligations.

Are Inherited Annuities Taxable?

Yes, inherited annuities are taxable. Any growth, interest, or investment gains are considered ordinary income and must be reported when funds are withdrawn. The taxable amount depends on whether the annuity is qualified (fully taxable) or non-qualified (partially taxable using a tax exclusion ratio).

What Is the 10-Year Rule for Inherited Annuities?

The 10-Year Rule requires non-spousal beneficiaries to withdraw the entire annuity balance within ten years of the original owner’s passing. This rule prevents indefinite tax deferral and applies to most inherited annuities, especially those in retirement accounts after the SECURE Act of 2019.

Can I Avoid Taxes on an Inherited Annuity?

No, taxes on inherited annuities cannot be avoided. However, spreading withdrawals over multiple years through options like life expectancy payouts or the Five-Year Rule can help manage annual tax obligations and reduce the overall tax burden.

What Happens If I Don’t Take Required Withdrawals?

Failing to take required withdrawals can result in IRS penalties and back taxes. Beneficiaries subject to the Five-Year Rule or 10-Year Rule must ensure timely withdrawals to comply with IRS regulations and avoid costly fines.