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.
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?
Selling an Inherited Annuity
- 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.
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- Investopedia. (n.d.). Annuitization. Retrieved from http://www.investopedia.com/terms/a/annuitization.asp
- The Motley Fool. (n.d.). Do I Pay Taxes on All of an Inherited Annuity, or Just the Gain? Retrieved from https://www.fool.com/knowledge-center/do-i-pay-taxes-on-all-of-an-inherited-annuity-or-j.aspx
- The Motley Fool. (n.d.). Tax Rules for an Inherited Non-Qualified Annuity. Retrieved from https://www.fool.com/knowledge-center/tax-rules-for-an-inherited-non-qualified-annuity.aspx
- Quarters, C. (n.d.). Can You Roll Over an Inherited Qualified Annuity? Retrieved from http://thefinancebase.com/can-roll-over-inherited-qualified-annuity-1812.html