Inheriting money can evoke mixed emotions. While it represents a gesture of care from a loved one, navigating the management of this windfall can be challenging.

If the inheritance involves an annuity, the situation can become complex. It’s crucial to grasp your choices and the precise terms outlined in the annuity contract before proceeding with any decisions.

This guide will outline the steps involved in inheriting an annuity, covering its mechanics and the tax considerations associated with various payout alternatives.

Here’s a comprehensive overview to help you navigate the process.

An annuity is a financial product typically offered by insurance companies. It involves a contract where the annuitant makes either a lump sum payment or a series of premiums in exchange for a guaranteed income stream in the future.

Upon the death of the annuity owner, what happens to the annuity depends on the specific terms outlined in the contract. Some annuities stop all income payments once the owner passes away.

Other annuities, however, provide a death benefit feature. This allows the owner to designate a beneficiary, such as a spouse or child, who will receive the remaining funds. The payout can either be the entire remaining balance in the annuity or a guaranteed minimum amount, typically whichever is greater.

If your loved one had an annuity, the contract will contain essential details. It will specify the beneficiary and outline the available options for the death benefit payout. Having this information readily available can guide you through the process of claiming your inheritance.

The death benefit of an annuity ensures a payout to a chosen beneficiary after the owner’s death. However, the specifics of this benefit can vary based on the type of annuity, the timing of the owner’s death, and any additional riders included in the contract.

Here’s an overview of common death benefit options:

  • Standard death benefit: This is typically included with the annuity at no additional cost. It guarantees that the beneficiary receives at least the amount originally contributed by the owner, minus any fees and withdrawals. For example, if the owner initially invested $100,000 and withdrew $50,000 over time, the beneficiary would receive $50,000 (minus fees).
  • Guaranteed increase death benefit: This option functions like the standard death benefit but includes an annual increase based on a small percentage of the initial investment. As a beneficiary, you would receive either the current value (standard death benefit) or the increased amount (standard amount plus, for instance, 3% annual growth for 10 years), whichever is higher.
  • Annuity death benefit riders: These are optional features that can be added to the annuity contract for an additional fee. A common rider is the stepped-up benefit, which guarantees the beneficiary receives either the highest value the annuity reached over its lifetime (minus fees and withdrawals) or the current value, whichever is greater. This rider provides protection against market declines but comes with higher ongoing fees.

Understanding the various death benefit options within your inherited annuity is crucial. Review the contract details carefully or consult with a financial advisor to clarify the specific terms and determine the best approach for managing your inheritance.

Once you inherit an annuity, you have several options for managing the funds. You can opt to receive a lump sum payment, which provides immediate access to the entire remaining balance of the annuity but comes with significant tax implications. Alternatively, you can choose to spread payments out over time to minimize taxes. In some cases, you may be eligible to roll the annuity into a specialized type of individual retirement account (IRA).

Choosing a lump sum payment means receiving the entire remaining balance of the annuity in one installment. While this option grants immediate access to the funds, it also entails paying taxes on the entire amount in the year of receipt.

If the inherited annuity is qualified (held within a tax-advantaged retirement account), you might have the option to roll it over into a new retirement account. This could include transferring funds into an inherited IRA, which is specifically designed to hold assets inherited from a retirement plan. Spouses generally have more flexibility, including the ability to withdraw funds over their lifetime. Other beneficiaries typically must withdraw all funds within 10 years of the owner’s death.

While you cannot make additional contributions to an inherited IRA, it offers significant tax benefits such as tax-deferred growth. Earnings within the inherited IRA grow without being taxed until withdrawals are made. When withdrawals are taken, they are generally reported as annuity income according to IRS guidelines, similar to how the original owner would have reported it.

Calculating taxes on an inherited annuity may seem intricate, but it largely hinges on whether the contributed funds were previously taxed.

For non-qualified annuities, which are funded with after-tax dollars, beneficiaries generally don’t owe taxes on the original contributions. However, any earnings distributed from the account are subject to ordinary income tax.

On the other hand, qualified annuities like IRAs and 401(k)s are funded with pre-tax dollars. Here, beneficiaries owe ordinary income tax on the entire amount withdrawn, encompassing both the initial investment and any earnings. There are exceptions for spouses inheriting qualified annuities, who can often roll the funds into their own IRA and defer taxes on future withdrawals.

At year’s end, the annuity company typically issues a Form 1099-R detailing the taxable portion of the distribution for that tax year.

In some cases, estate and inheritance taxes may also need consideration. These taxes apply to the deceased’s entire estate, not solely the annuity. However, they typically affect only very large estates, so for most heirs, focusing on the income tax implications of the annuity is paramount.

Inheriting an annuity can be both complex and financially advantageous. It’s crucial to grasp the contract terms, explore payout choices, and assess tax implications to make well-informed decisions. Consulting a financial advisor can provide valuable guidance in navigating these intricacies and optimizing the benefits of your inheritance.