Inherited annuities can provide financial relief for a beneficiary, but may also carry a tax burden.
What Is an Inherited Annuity?
An annuity is a financial investment designed to protect financial assets and ensure stability over a set period of time. Due to the many benefits of this financial tool, individuals with personal injury lawsuit structured settlements, lottery recipients, and retirees looking to further invest in their nest egg frequently use annuities as a way to secure their futures. Some annuities also feature a death benefit that allows for a beneficiary to receive an annuitant’s payments following their death. If the annuitant happens to die before the term of their annuity contract ends, the designated beneficiary will inherit the annuity investment in the form of consistent monthly, quarterly or yearly payments.
How Does an Inherited Annuity Work?
For an added fee, annuitants can purchase a death benefit rider, which is an attachment to the original annuity contract. Annuitants will receive payments from their annuity for the term of their contract. If the annuitant dies before the contract ends, and they have a death benefit, their beneficiary will receive their payments in the original annuitant’s stead. Beneficiaries can inherit two types of annuities: qualified and non-qualified.
A qualified annuity is a financial investment connected to retirement plans, including death benefit pensions, tax-sheltered annuities — also referred to as 403(b) plans — and IRAs, and is paid with pre-tax dollars. If you are the annuitant’s spouse, you can roll all assets from the qualified annuity into another plan and treat it as your own. This also includes a 401(k). If you are not a spouse, the annuity payment will be disbursed as a lump sum or you can set up a separate IRA account to receive the money once you inherit it. A non-qualified annuity is an investment purchased outside of a work-related retirement plan using after-tax dollars. These annuities have already been subject to income tax, however, any interest earned will be taxed upon withdrawal. If a beneficiary inherits this type of annuity, they will be required to pay taxes on the growth.
Distribution Options
Beneficiaries inheriting an annuity have a few different options in receiving the disbursed payments:
- Lump Sum Payment – The designated beneficiary can receive the full death benefit as a one-time lump sum payment upon the annuitant’s death. A lump sum payment provides the beneficiary with the flexibility to pay off debt and larger expenses at one time.
- Five-Year Rule – The five-year rule requires the inherited beneficiary to receive the full distribution within five years of the annuitant’s death. The beneficiary can take smaller amounts during the five-year period until the full annuity has been disbursed, take the full annuity at the fifth year, or take all disbursement payments immediately following the annuitant’s death. The five-year rule is the only disbursement option available to estates, charities or trusts named as beneficiaries.
- Nonqualified Stretch – The nonqualified stretch, or the life expectancy method, is a distribution option that can help beneficiaries maximize the most benefits from an inherited annuity. The nonqualified stretch allows for the beneficiary to receive the minimum annuity distribution through yearly payments based on their life expectancy. They can control when payments are disbursed and can also name a beneficiary to receive remaining payments in the event of their death.
- Periodic Payments – Inherited beneficiaries can choose to receive a single-life or term-certain annuitization option. In a single-life annuity payout, proceeds are disbursed until the annuitant’s death. If there is still a balance after their death, the remaining balance is surrendered to the insurance company. In a term-certain annuity payout, annuity payments are disbursed for a fixed period of time. Once the term has ended, the inherited annuitant will receive no more payments even if they are still alive.
Are Inherited Annuities Taxable?
Inherited annuities come with a number of tax implications, especially if the inherited beneficiary is a non-spouse. If the beneficiary is a spouse of the deceased annuitant, they can carry on with the original annuity contract without any immediate tax implications.
However, if the beneficiary is a non-spouse, the taxes depend on the payout choice. If the non-spouse beneficiary chooses a lump sum payout option, they will owe taxes on the interest earned on the original premium. They will not have to pay income tax on the premium. If the beneficiary chooses to continue with annuity payments, each payment will be taxed individually. Choosing this option spreads out the tax liability over a longer period of time.
This may be especially beneficial because an annuity is considered a financial asset in the deceased’s estate, and is therefore subject to estate tax. The annuity beneficiary will be responsible for paying this estate tax.
Selling an Inherited Annuity
While receiving monthly, quarterly or yearly payments may be beneficial, some inherited annuitants may choose to sell their annuity to pay for emergency expenses, tuition, or to alleviate debt.
Inherited annuitants have the added option to sell their inherited annuities in one of two ways:
- Partial Sale – Annuitants can sell a period of their annuity disbursement or they can sell a portion of each payment. If the annuity payments last 10 years, beneficiaries can sell years of their payments in exchange for a lump sum. After that term, they will begin or continue to receive the remaining payments. Beneficiaries can also sell a portion of each payment in exchange for a lump sum and a smaller continual payment.
- Entirety – Inherited annuitants can sell all their continual payments through the term of the annuity contract. In exchange for this transaction, the beneficiary will receive a one-time lump sum payment.
If you have an inherited annuity and are interested in selling it, CBC Settlement Funding can provide you with cash now. Our experienced team will walk you through the process of selling your inherited annuity and answer any questions you may have. If you choose to sell, we provide free quotes and legal services to get your sale through the courts quicker so you can get your money faster.
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