Advertisement
retirement

Inheriting an Annuity? Here’s a Little-Known Way to Stretch Its Tax Benefits

There are a few different ways beneficiaries of annuities can claim their inheritance. One you might not have heard of is called an "annuity stretch." It gives non-spouse beneficiaries a way to receive income and defer taxes.

One of the biggest advantages of an annuity, tax deferral, can be lost when anyone other than a spouse inherits an annuity. Then, all deferred taxes on the gains must be paid sooner or later. It’s usually better to pay them later rather than sooner — and there are different ways to do that.

Advertisement - Article continues below

If the beneficiaries take the proceeds as one lump sum or even distributions over a few years, they might get kicked into a higher tax bracket. For an annuity with a large untaxed gain, that could mean that a lot of the money would go to pay state and federal income taxes.

This is a problem only for non-spouse beneficiaries. A surviving spouse can usually just keep the annuity intact and continue to defer taxes.

Two Traditional Annuity Inheritance Routes

Fortunately, there is a little-known way for a non-spouse beneficiary to spread out payments and taxes, continue to benefit from tax deferral and thus ultimately receive more money. But first, here are the two main ways people have typically received annuity money:

The default is the five-year rule. Under it, the beneficiary or beneficiaries have five years to take out the proceeds of the annuity. They can take them out gradually or in a single lump sum anytime up until the fifth anniversary of the owner’s death.

Advertisement - Article continues below
Advertisement
Advertisement - Article continues below

But even a series of five equal distributions has tax drawbacks. An annuity normally includes both gains and non-taxable principal. Unfortunately, gains are distributed first. So, for instance, if the annuity has $50,000 in gains and $50,000 in principal, you won’t receive the tax-free principal until after you’ve received all of the gains.

The second method is annuitization. Here, the beneficiary directs the insurer to annuitize the proceeds and turn the money into a stream of income — for either a set period of time or a lifetime.

Besides guaranteed monthly income, another advantage is partial tax deferment. Each payment includes both taxable gains and non-taxable return of premium — the exclusion amount. Annuitization can be a great choice, but you give up flexibility. Once you’ve annuitized, there’s no cash value. You’ve given up the money in exchange for long-term income.

Enter the Annuity Stretch

Aside from the five-year rule and annuitization, the newest way people can receive annuity money is called a non-qualified annuity stretch. Non-qualified means the annuity is not held in an IRA or another type of qualified retirement account. It’s an underused planning tool, but more insurance companies are offering this option now.

The stretch method is a bit more complex but worth considering. Here, the beneficiary receives monthly, quarterly or annual payments based on his or her life expectancy. If there are multiple beneficiaries, each one is free to choose his or her own method.

Advertisement - Article continues below

Since the payments are spread out, annual income tax bills are smaller. And the additional taxable income is less likely to push the recipient into a higher tax bracket than a lump-sum. The money remaining in the annuity continues to grow tax-deferred.

Flexibility is another plus. The beneficiary can cancel payments at any time and receive whatever’s left as a lump sum.

What happens if the beneficiary dies prematurely? For example, suppose the beneficiary’s life expectancy was 20 years, but he or she dies after just 10 years. A successor beneficiary (such as the grandchild of the original owner) can receive the balance of remaining payments. This is a unique advantage of the stretch option.

The Bottom Line

No one distribution method is best for everyone. You need to consider your tax situation and financial needs and compare options before you decide.

Non-spousal beneficiaries have one year from the death of the annuity owner to set up the stretch distribution. Only natural persons (not trusts or charities) can choose the stretch option.

Advertisement

About the Author

Ken Nuss

CEO / Founder, AnnuityAdvantage

Retirement-income expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. It provides a free quote comparison service. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities.

Advertisement

Most Popular

11 Dividend-Paying Stocks You Should Think Twice About
dividend stocks

11 Dividend-Paying Stocks You Should Think Twice About

Dividend-paying stocks often can be a store of safety, but 2020 has been difficult on income equities. These 11 picks look like shaky plays despite th…
September 21, 2020
How To Buy a Roth IRA When You Make Too Much To Qualify For One
Roth IRAs

How To Buy a Roth IRA When You Make Too Much To Qualify For One

With their tax-free growth and tax-free withdrawals, Roth IRAs are a great deal — if you qualify. If you don’t, well, there’s still a way to get into …
September 23, 2020
Medicare Basics: 11 Things You Need to Know
Medicare

Medicare Basics: 11 Things You Need to Know

There's Medicare Part A, Part B, Part D, medigap plans, Medicare Advantage plans and so on. We sort out the confusion about signing up for Medicare --…
September 16, 2020

Recommended

The Annuity With a Tax-Planning Twist
Financial Planning

The Annuity With a Tax-Planning Twist

A qualified life annuity contract helps retirees with guaranteed payments to last their entire lives.
September 21, 2020
Now’s the Time for Estate Tax Planning
Financial Planning

Now’s the Time for Estate Tax Planning

There's a wealth of opportunity with IRS interest rates at an all-time low and the federal estate and gift tax exemption at an historic high.
September 18, 2020
A Step-by-Step Guide to Being an Estate Executor
retirement

A Step-by-Step Guide to Being an Estate Executor

Whether you’re planning ahead for your own heirs or have been asked to serve as an executor of an estate for someone else, it pays to understand what …
September 17, 2020
5 Unfortunate Estate Planning Myths You Probably Believe
estate planning

5 Unfortunate Estate Planning Myths You Probably Believe

These all-too-common misconceptions can steer your estate plans in the wrong direction right from the start. Here’s how to overcome them and tips to b…
September 17, 2020