Inheritance Annuities — Know Your Annuity Contract
Why It Matters:
- Annuities can provide a consistent income stream after retirement.
- You can customize an annuity contract with estate planning in mind.
- Beneficiaries should be aware of what happens when they inherit an annuity.
As previously discussed in an article on estate planning, managing your assets early on can greatly help your loved ones in the future. However, even with estate planning in place, many people are still unaware of how some aspects of their financial plan work, and what happens if they should pass.
Annuities are a great example. Based on 2020 life insurance statistics, annuities account for 48% of direct premiums written by life insurers.1 With an increase in demand, it’s more important than ever to fully understand their contract terms and how beneficiaries of an annuity could be affected. Before we get to specifics on an inherited annuity, let’s review some annuity basics.
For starters, what is an annuity? Annuities are a long-term insurance product that provides a guaranteed income through a stream of payments backed by the claims-paying ability of the issuing insurance company. They’re designed to help reduce the risk of outliving one’s money with today’s increased longevity and can be a valuable part of an overall financial plan.
How do annuities work? An investor, also known as the owner, pays a premium to an insurance company. This investment is structured to grow tax-deferred until the funds are withdrawn during retirement. However, because invested cash is illiquid and subject to withdrawal penalties, they’re not recommended for younger individuals or for those with liquidity needs.2
Depending on the contract, an annuitant will receive regular payments at certain intervals throughout their lifetime. Usually, the annuity owner customizes a contract with their insurance partner to specify any payout options.
For a fee, annuity owners can also include a death benefit for beneficiaries to receive the remaining payments if the annuitant dies before the terms of the contract ends. However, the contract must name these beneficiaries so they can claim the inherited annuity. Sometimes, annuity owners opt to keep an annuity whole for one beneficiary, spread it out for different beneficiaries, or even include non-profit organizations.
There are many ways annuities can be structured, based on when their distribution begins as well as their inherent growth potential and market risk. These include factors such as:
When Payout Begins
Immediate annuity: An annuity that is converted to an income stream for the annuitant immediately. Once you pay the principal in a lump sum, you can receive payouts right away.
Deferred annuity: An annuity that begins paying at a future date determined by the owner. You make contributions ahead of time, allowing your money more time to accrue interest for higher payouts.
How The Value Is Determined
Fixed annuity: An annuity that pays a guaranteed minimum rate of return and provides a fixed series of payments, under the conditions determined in the contract.
Variable annuity: An annuity with a value based on the performance of an underlying investment, offering greater growth potential as well as more market risk and potential loss of principal.
Fixed index annuity: An annuity with a value based on the performance of an underlying index like the S&P 500® index.
Whether They’re Qualified or Non-Qualified
Qualified: Qualified annuities are funded with pre-tax money, have limits on how much money may be invested in them, require all funds to be taxable at distribution, and require that RMDs (Required Minimum Distributions) must begin at age 72.
Non-Qualified: Non-qualified annuities are funded with post-tax dollars, do not have contribution limits, allow only gains to be taxed, and do not require RMDs.
Death Distribution Options: There are also different methods for death benefit distribution, such as:
Lump sum payment: This one-time lump sum payout is distributed upon the death of the owner. The full death benefit allows beneficiaries flexibility to pay off debt or large expenses.
5-year rule/10-year rule: This option requires the beneficiary to receive the full distribution of the total dollar amount within five years of the owner’s death. The beneficiary can withdraw smaller amounts during the five-year period, take the full annuity in the fifth year, or receive all payments immediately following the owner’s death. This is the only option for estates, charities, or some trusts named as beneficiaries. The 5-year rule is subject to the “at least as rapidly rule,” which requires that payments be taken at least as rapidly as they were required to be taken by the decedent. For defined contribution plans, the SECURE Act replaced the 5-year rule with a 10-year option for designated beneficiaries. The 10-year delay is like the 5-year-rule, except it requires the beneficiary to receive the full distribution of the total dollar amount within ten years of the owner’s death.
Non-qualified stretch: This is for an inherited non-qualified annuity outside an IRA. It allows non-spouse beneficiaries to receive RMDs based on their life expectancy, allowing them to name a beneficiary for their own annuity inheritance.
Inherited IRAs: There is also an option for payments over the life of a beneficiary for qualified plans. However, this option is only available to “eligible designated beneficiaries.” To qualify as an eligible designated beneficiary, the person must meet at least one of the following criteria:
- the surviving spouse of the employee
- a child of the employee who has not reached the age of majority
- a chronically ill individual
- any other person who is not more than 10 years younger than the employee
Reviewing Your Annuity
Annuities should be reviewed at least once a year. Consult your financial professional to discuss stock market performance, interest rate conditions, company ratings, and any possible changes.
You should also adjust annuity inheritance beneficiaries whenever major life changes occur. Fortunately, the IRS has made it possible to transfer from an inherited non-qualified annuity to another while maintaining a tax-deferred status. Contract owners must meet the requirements of Section 1035 exchange to preserve the original policy’s tax basis and defer the recognition of gain. The same is true if you are moving money from an IRA into a qualified annuity.3 However, the annuity may have surrender charges and fees associated with such a transfer.
Managing Annuity Taxes
Annuities won’t be subject to income taxes as the money grows. As it is intended for retirement investing, however, withdrawals made from an annuity before age 59½ may be subject to a 10% IRS tax penalty.4 Of course, this early distribution penalty does not apply if you have an inherited annuity. As a spouse beneficiary, you can also carry on with the original annuity contract without immediate tax implications.
Taxes kick in for non-spouse beneficiaries, depending on the payout choice. Lump sum death payouts are taxed on interest earned on the original premium, while periodic payments are taxed individually. Either way, annuity proceeds are taxable to the beneficiary as ordinary income tax. In any situation, it’s best to check with a professional who has accounting expertise on income taxes, financial reporting, and auditing.
A good financial professional will help you develop short-term and long-term financial strategies for annuities you have or may obtain, including best practices for distributions and beneficiaries in your estate planning.
Things to Consider:
- Different annuity distribution options may be chosen according to your needs.
- Annuities should be reviewed regularly and updated to reflect changes in beneficiaries.
- It’s important to know how your beneficiaries will be taxed on your annuities, so you can plan for a tax-efficient way to manage them.
1 “Facts + Statistics: Life Insurance,” Insurance Information Institute, accessed January 2022
2 “Annuity,” Investopedia, January 2022
3 “Section 1035 Exchange,” Investopedia, June 2020
4 “Topic No. 410 Pensions and Annuities,” IRS.gov, January 2022
Neither Transamerica nor its agents or representatives may provide tax, investment or legal advice. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely on their own independent tax and legal professionals and financial professional regarding their particular situation and the concepts presented herein.
Transamerica Resources, Inc. is an Aegon company and is affiliated with various companies which include, but are not limited to, insurance companies and broker dealers. Transamerica Resources, Inc. does not offer insurance products or securities. The information provided is for educational purposes only and should not be construed as insurance, securities, ERISA, tax, investment, legal, medical or financial advice or guidance. Please consult your personal independent professionals for answers to your specific questions.