​Managing Taxes on Inherited Annuities

One of the key benefits of an annuity—tax deferral—can be lost when someone other than a spouse inherits it. Non-spousal beneficiaries are typically required to pay taxes on the deferred gains sooner or later, and it’s usually advantageous to delay those taxes as long as possible. 

If the beneficiary chooses to take the proceeds as a lump sum or in distributions over a few years, they risk being pushed into a higher tax bracket. This is especially problematic for annuities with significant untaxed gains, as a substantial portion of the proceeds could end up paying state and federal income taxes. 

For surviving spouses, this issue doesn’t apply; they can continue to defer taxes and keep the annuity intact. Fortunately, non-spousal beneficiaries have options to spread out payments, defer taxes, and maximize their inheritance too. 

Distribution Options for Non-spousal Beneficiaries 

1. The Five-Year Rule (Default Option): 

Under this rule, beneficiaries must withdraw the annuity’s proceeds within five years of the owner’s death. Withdrawals can be taken gradually or all at once, any time before the five-year deadline. 

• Tax Drawback: Gains are distributed first. For example, in an annuity with $50,000 in gains and $50,000 in principal, you’ll pay taxes on the gains before accessing the tax-free principal. 

2. Annuitization: 

This method converts the annuity proceeds into a steady stream of income, either for a fixed period or the lifetime of the beneficiary. 

• Advantages: Provides guaranteed income and partial tax deferment. Each payment consists of taxable gains and a nontaxable return of premium know as the “exclusion amount”. 

• Disadvantage: Loss of flexibility. Once annuitized, the annuity has no cash value, and the income stream cannot be undone. 

3. The Nonqualified Annuity Stretch Out (Best for Tax Deferral): 

This underutilized planning tool allows beneficiaries to spread payments—and taxes—over their life expectancy. “Nonqualified” means the annuity is not held within an IRA or other qualified retirement account. 

• Key Benefits: 

  • Smaller annual tax bills since income is spread over time. 

  • Reduces the risk of being pushed into a higher tax bracket. 

  • The remaining funds in the annuity continue to grow tax deferred. 

• Flexibility: Payments can be received monthly, quarterly, or annually. Beneficiaries can also cancel at any time and take the remaining funds as a lump sum. 

• Successor Beneficiaries: If the beneficiary dies prematurely, a successor (such as a grandchild) can inherit the remaining payments. 

Choosing the Best Option 

No single method is best for everyone. Beneficiaries should carefully consider their tax situation and financial goalsbefore deciding. 

Important Notes: 

• Non-spousal beneficiaries must set up the stretch option within one year of the owner’s death. 

• Only natural persons (not trusts or charities) can choose the stretch option. 

By understanding these options, beneficiaries can make informed decisions to preserve more of their inheritance while managing taxes effectively. 

For further guidance on annuity distribution as well as exploring tax planning strategies to safeguard your financial future, feel free to contact us. 

barry.boscoe@brightonadvisory.com  

Office: 818-342-9950 

Mobile: 818-802-0686