“You cannot avoid paying taxes on an inherited annuity, but there are several things you can do to defer the pain.” Joe Uppleger
While inheriting an annuity from a loved one can be a welcome windfall, particularly as you plan your retirement, there are tax implications that you need to consider. The method of receiving benefits you select and how the inherited annuity is structured will determine how much tax you’ll owe and when you will be required to pay that tax.
What are inherited annuities?
Annuities are income and retirement products that pay out a steady, reliable amount of income over a specified period. Most annuities are paid for up-front, typically with a lump sum. While many retirees purchase annuity products to provide an additional income stream in retirement, some kinds of annuities also provide payments to beneficiaries.
Annuities are reasonably flexible in terms of how their design. Purchasers negotiate the options for their annuity with the provider at the time of purchase. A standard option available is to include the spouse as a beneficiary who receives payouts when the annuity owner passes. Creating an inherited annuity is one thing seniors choose when planning a legacy. However, if you are not a surviving spouse, you must understand all your distribution choices and the tax consequences of each. In addition, it’s a good idea to remember that all the gains stay with that policy when you inherit it.
Tax on inherited annuities is either paid on the lump sum or on the fixed payments. Payouts are treated as ordinary income by the IRS, meaning you pay as much as 37%, depending on your tax bracket. If the owner purchased the annuity with “after-tax” money, the beneficiary would owe tax on all gains but not on the principal. A portion of each payout to a beneficiary is considered a “tax-free return of principal.” This treatment might help you spread your tax liability over time, but only if you don’t choose the lump-sum payout option.
What are your payment choices?
As a beneficiary who is not a surviving spouse, you have three basic options for payouts from an inherited annuity. You may select a lump-sum payout, total payout over the next five years, or you could annuitize the payouts over your lifetime, provided you elect to do so within sixty days. Each option comes with its’ own set of pros and cons, which you should discuss with your annuity specialist, tax planner, or another financial professional. You can also get material from the IRS website that helps clarify some of the potential tax issues surrounding inherited annuities.
Summing it up:
An inherited annuity can be a significant boost to your retirement planning, especially if you are careful with your payout decisions. However, you will need to weigh the potential tax bite against not having that cash to use right now. Making the wrong decision with an annuity that you’ve inherited could result in losing as much as 50% of it to federal and state taxes. While you cannot avoid paying taxes when you inherit an annuity, you can select strategies that will defer your tax pain. It’s important to understand that the rules for deferring taxes on inherited annuities are different for beneficiaries who are not surviving spouses. Depending on the annuity’s structure, you may also want to look into advanced tax planning methods such as 1035 exchanges.