Beneficiary of an Annuity? Help Lower Your Tax Burden with a Transfer to a Qualified Retirement Account

A lot of annuities carry death benefits, which is why it’s not unusual for someone to call us for advice after inheriting a fixed annuity. It’s not like inheriting a lot of other things, such as cash or property, because you’re inheriting a contractual obligation from that person’s insurance company. It doesn’t help that a lot of the people who inherit annuities aren’t familiar with them. A beneficiary on an annuity has a number of choices to make — how you want to use the annuity you’ve inherited, as well as how you want to deal with the taxes.

Tax Considerations When Inheriting an Annuity

The tax on an inherited annuity is usually based on how much over and above the principal you receive. This can change depending on whether the annuity is qualified or non-qualified. Because taxes follow the contract, any tax the owner originally deferred, you’ll have to pay.

A qualified annuity is simply one purchased through an IRA, 401(k), or other retirement plan that allows it to be funded with an annuity, in which the income tax due on the premium was deferred because it was paid with before-tax funds. A non-qualified annuity is one purchased outside of a retirement account with after-tax funds. Any amounts where the tax was deferred will be due once you withdraw the funds.

In a non-qualified annuity, the tax will be due on anything over the principal because the tax on the principal was already paid by the original owner. For a qualified annuity, the tax will be due on the entire amount. In this case, the amount is taxed as ordinary income, rather than at the lower capital gains rate, because this amount isn’t considered investment income, but proceeds from an insurance policy.

This is what happens as soon as the money leaves the annuity. But you might have an option for continuing to defer those taxes and that involves transferring it to a new retirement account or annuity.

Other Options for Inheriting Annuities

Your options for what you can do with your death benefit will depend on the type of death benefit you receive. Generally, you will be given the option to cash out in a lump sum, start receiving ongoing payments and become the annuity new owner, or possibly, transfer the annuity to another account.

If you take out a lump sum, you’ll have to pay taxes on the whole amount withdrawn. Tax rates for regular income can get as high as 35%. Another option, if available, might be to take over the annuity’s payments. In that case, you’ll be responsible for taxes on the withdrawals as they happen.

The key to continuing to defer those taxes is to keep the annuity in a qualified account by doing a transfer to another qualified retirement account. When you transfer it, it becomes part of your own retirement fund. This means you can continue deferring taxes on it until you reach required minimum distribution age, at which point you are generally required to begin taking withdrawals each year.1 How this transfer is completed will depend on who you inherited the annuity from.

How Spousal And Non-Spousal Beneficiaries Can Manage Their Inheritance

How you can handle transferring an inherited annuity depends on your status as a beneficiary. If you’re a spousal beneficiary, you can transfer a qualified annuity into your own IRA or 401(k) account after inheriting it with no taxes incurred at the time. Of course, this is only allowed if the annuity owner was not yet taking annuitization payments. If the owner was taking payments, you must continue taking them, at least, at the same frequency. This is often the case with a non-qualified annuity because many non-qualified annuities are immediate ones.

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If you’re a non-spousal beneficiary inheriting a qualified annuity, the transfer process will be a little different. In this case, you’d have to create something called an inheritance IRA in the decedent’s name to benefit you. You can’t put anything else in this account nor can you transfer the account to anyone else. The sole purpose of the account has to be to hold the inheritance.

You cannot roll a non-qualified annuity into any IRA or 401(k) account nor is it recommended because you would lose the benefit of the principal paid with after-tax dollars by putting it into a tax-deferred account. In addition, these rules apply to deferred annuities, as you can’t roll over the account if annuity payments have already started.

Finally, keep in mind that these rules have to do with inherited annuities in which you become the owner only after the death of the original owner. If you’re dealing with a true joint or survivor annuity, benefits will continue as per your contract. This is because you already owned jointly with the decedent and have survivorship rights because of that joint ownership.

Inheriting an annuity can be a complicated process and can give you a hefty tax bill, or possibly even knock you into a higher tax bracket. If you’ve inherited an annuity, your best bet is to talk to a qualified financial professional in Retirement HQ’s network to see what your options are. Retirement HQ and their network of insurance and financial professionals do not offer tax or legal advice. Consult with qualified tax/legal advisors concerning your own situation.

Show 1 footnote

  1. Annuity distributions are subject to ordinary income taxes, and if taken prior to age 59-1/2, may be subject to an additional 10% federal tax penalty.