Inheriting an annuity: What to do, rules & tax Info

Annuities are one of the many tools used to build wealth and secure financial well-being. Inheriting an annuity can do the same for you as a beneficiary, but it requires you to make some decisions on how to take the funds. It also comes with some potential tax implications.

The best thing to do with an annuity differs from person to person, so you may not know where to start if you recently inherited an annuity. Here's what you should know.

Annuities are financial contracts between insurance companies and annuity owners. While there are different types of annuities, each with distinct benefits and features, their key goal is that they provide income in retirement. Depending on the type, annuities can be funded with either a single premium or flexible premiums. Because the payout is a contractual option, people commonly use annuities to ensure they can generate a predictable source of income in retirement.

In addition to the insurance company, other parties are involved in an annuity. There's the annuity owner, the annuitant (the person whose life is used to determine the annuity payout, who also can be the owner) and the beneficiary. Beneficiaries can be individuals, trusts or charitable organizations.

If you're a beneficiary of an annuity, you may receive a death benefit as part of the estate claims process. The settlement amount will depend on whether the annuity owner was in the accumulation stage or the distribution stage.

If the annuitant was in the accumulation stage at the time of their passing and the contract provisions included a death benefit, it can be paid to the beneficiary either as a lump sum or as a series of payments depending on the contract.

Annuity owners can choose different payout options, such asa fixed period of 15 or 20 years, or joint life income, which passes the remaining funds to a beneficiary. If the owner dies before the end of a fixed-period annuity, a death benefit is available. For example, if the owner chose a 20-year guaranteed payout and died in year 10, the beneficiary can either continue receiving payments or take a lump sum.

A joint income payout covers the owner and spouse, with options for continuing full or partial payments to the surviving spouse.

When managing an inherited annuity, it's important to understand the distribution rules that apply to your specific annuity contract. Depending on the type of annuity and the relationship between the original owner and the beneficiary, many beneficiaries have a timeline for withdrawing the money. How you withdraw the annuity funds also will affect the taxes you may owe.

Most beneficiaries of a nonqualified annuity must deplete the account within five years of the owner's death, whether by taking all the proceeds at once or over that five-year period. Spouses and certain other beneficiaries have additional options. Contact the insurance company for specific contract details.

As an exception to the five-year rule, the IRS also allows you to stretch the payments out over a period not exceeding your life expectancy. This option may not be available in all contracts or when the beneficiary isn't a living person, such as a trust or charity.

For a qualified annuity, such as one contained within an IRA, most beneficiaries must deplete the account within 10 years of the owner's death. Spouses and certain other beneficiaries have additional options.

As the beneficiary of an inherited annuity, you'll generally have tax obligations on the payouts you receive. The exact tax implications vary depending on the type of annuity, your tax status and how you choose to receive your payout.

To understand the potential tax consequences of inheriting an annuity, it's essential to understand the difference between qualified annuities and nonqualified annuities. The distinction has to do with how they are purchased:

• Qualified annuities are purchased with pretax dollars inside of retirement accounts.
• Nonqualified annuities are purchased with after-tax money.

Annuities are tax-deferred. This means you only incur tax obligations once you receive payments. When you receive a payout from an annuity—either as the owner or the beneficiary—the amount of your payout subject to taxation depends on whether the annuity is qualified or nonqualified.

Because the money used to purchase a qualified annuity was not usually taxed to begin with, the entire distribution of a qualified annuity likely will be included in your income. This is the same tax treatment as any other investment held in a tax-deferred retirement account, such as a workplace 401(k).

In contrast, payouts from nonqualified annuities are only partially taxable. Since the money used to buy the annuity already has been taxed, only the portion of the payout that's attributable to earnings will be included in your income.

How you choose to receive the death benefit will help determine the tax implications:

• Taxation of lump-sum payouts. When you take a lump-sum payout, you must include the entire taxable portion of your payout as income in the year the distribution occurs. This is usually the least efficient payout choice for tax purposes, especially if the death benefit is large enough to place you in a higher tax bracket.
• Taxation of payment streams. When the death benefit is paid out as a stream of payments, the tax liability is spread out over multiple tax years. If the contract has been annuitized, each payment from a nonqualified annuity includes a portion of the gain and the original after-tax contribution, so they're only partially taxable. The percentage of each payment that isn't included in your taxable income is called the exclusion ratio. For a qualified annuity, the entire payment will be reported as taxable.

If you inherit an annuity, it's important to consider taxes when taking a benefit. Spreading your payments out over the longest period of time possible may result in the most efficient taxation. The IRS may allow you to stretch payments from the annuity out over your life expectancy through the nonqualified stretch provision.

If you're a surviving spousal beneficiary, you have a few options for moving forward. For instance, you can transfer the contract into your name if the spouse is the sole, primary beneficiary. If you choose this option, you can continue with the original terms of the annuity contract as though the annuity were your own. This can be a valuable strategy if you intend to use income from the annuity as a critical part of your retirement plan.

If you want the annuity death benefits to go to your children upon your death, you can name them as beneficiaries or name a trust to provide for their care. The choice depends on their age, needs and level of responsibility. Annuity death benefits also can be a great way to leave a charitable legacy and provide financial help to a cause you care about.

These can be complex decisions, so it's wise to consult with a financial advisor or estate attorney before taking action.

If you inherit an annuity, the lump sum of money or regular payments can help you reach your own financial goals. Consider these strategies for utilizing the annuity funds:

Pay down debt. Funds from a lump sum or regular distributions can help you pay down or pay off a mortgage, student loan or other large debt.

Save for a home. Money from the annuity can help you build a down payment fund or cover expenses for new home repairs and upgrades.

Boost your retirement savings. Consider using funds from an inherited annuity to bolster your retirement savings, especially as you approach your retirement age. Savers age 50 and above can put more money away in 401(k) and IRA plans through catch-up contributions.

Increase your emergency fund. The more you have saved for emergencies, the more flexibility you'll have if you need to use your emergency funds for a longer period of time.

Donate to a charitable organization. Using the money you received as a beneficiary can be a way to support the causes you believe in and honor the memory of the annuitant.