Inherited an Annuity? Here Are 2 Smart Ways to Manage the Tax Hit, Courtesy of an Annuity Pro
When inheriting an annuity, a beneficiary, other than a spouse, can face a big tax bill. Choosing annuitization or the "stretch" option lets you soften the blow by extending tax deferral.
People other than spouses who inherit annuities can be hit hard with taxes. But there are ways to lessen the blow.
Here's the background.
Unlike qualified financial accounts such as IRAs and 401(k)s, most nonqualified accounts don't provide tax deferral. A nonqualified deferred annuity, however, allows earnings to accumulate tax-deferred.
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This is a major benefit of annuities because deferral lets your money compound faster without taxes eroding your returns.
Generally, only a surviving spouse can inherit a "nonqualified annuity" and enjoy full tax deferral for their lifetime, assuming no interest withdrawals are made.
But the IRS and state tax collectors eventually will take their share of all the accumulated taxes that were put off. The "nonspouse" beneficiaries will pay those taxes.
If a beneficiary takes the proceeds as a lump sum or large distributions over a few years, they might get kicked into a higher tax bracket. For an annuity with a large untaxed gain, a lot of the money would go to the taxman.
Fortunately, a nonspouse beneficiary can spread out payments and taxes to ultimately net more money:
- Annuitization is one way
- The annuity stretch is another way, if your annuity company offers it
The default method can cause a tax bomb
The default way is the five-year rule. Nonspouse beneficiaries can always take up to five years to receive the proceeds. They can take them gradually or in a lump sum anytime up until the fifth anniversary of the owner's death.
Spreading proceeds over five years sounds good, but there's a problem: An annuity normally includes both reinvested gains and nontaxable principal. The gains are distributed first.
Consider an annuity with $100,000 in gains and $100,000 in principal. The beneficiary won't receive the tax-free principal until after receiving all of the gains.
Someone who inherits this annuity and takes proceeds evenly over five years would still have $40,000 of additional taxable income in year one, which would likely result in a higher federal income tax bracket and perhaps a higher state tax rate.
Someone who waits five years would have that $100,000 taxable gain plus any additional interest earned in the interim.
For some people, however, delaying can pay off. For instance, in year one, the individual could be working and in a high tax bracket, but in year five, they could be retired and in a lower tax bracket.
Annuitization: More tax deferral
The other option that's usually available is annuitization. Here, the nonspouse beneficiary directs the insurer to annuitize the proceeds: Turn the money into a stream of income for either a set period of time or a lifetime. Nearly all insurers provide an annuitization option.
Besides guaranteed monthly income, annuitization offers continuing partial tax deferment. Each payment includes both taxable gains and nontaxable 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 traded that for long-term income.
I'm a big advocate of having a lifetime annuity. It offers guaranteed income you can't outlive — your own private pension that serves as longevity insurance.
But I recognize that many are unwilling to exchange cash liquidity for future income.
Stretching it out without annuitizing
The stretch method is more complex but worth considering. Here, the beneficiary receives monthly, quarterly or annual payments based on his or her life expectancy according to an IRS table.
Since the payments are spread out over the life expectancy, annual income tax bills are smaller. And the additional taxable income is far 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. Many insurers allow the beneficiary to stop the scheduled payments and take the remaining balance as a lump sum.
What happens if the beneficiary dies prematurely? Suppose the beneficiary's life expectancy was 20 years, but he or she dies after just 10 years. Most insurers permit a properly named successor beneficiary (such as a grandchild of the original owner) to continue receiving the remaining payments. This is an important advantage of the stretch option.
Not so fast!
Unfortunately, a beneficiary often can't use the stretch plan because the issuing insurance company has to be willing to support it. My ballpark estimate is that perhaps only 15% to 20% of companies do.
Nonspouse beneficiaries generally have one year from the death of the annuity owner to set up the stretch distribution. Only people — not trusts or charities — can choose it. Only nonqualified annuities are eligible.
When available, the stretch option can be applied to a multi-year guarantee annuity (MYGA), which behaves much like a bank certificate of deposit, or an indexed annuity.
Ask questions
No one distribution method is best across the board. Fortunately, if there are multiple beneficiaries, each one is free to choose the option that is best for them.
If you're an annuity buyer, ask your agent if the issuing insurer offers a stretch option if that's important to you.
If you're a nonspouse beneficiary, consider your tax situation and financial needs and compare your two or three distribution options before you decide on one.
Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling (800) 239-0356. The firm also offers an income-annuity quoting service. There are no fees or charges for the firm's services; 100% of the client's money goes to work for them in their annuity.
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