How Are Inherited Non-Qualified Annuities Taxed?
Image: Bigstock
Inheriting a non-qualified annuity can feel like receiving a financial windfall — until taxes come into play. Unlike qualified annuities tied to retirement accounts like IRAs, non-qualified annuities are purchased with after-tax dollars. This means that while the original owner didn’t get an upfront tax break, they enjoyed tax-deferred growth on earnings. Once inherited, beneficiaries face very specific tax rules that can significantly impact how much of that money they ultimately keep.
The core issue is that the money originally invested (the principal) has already been taxed and isn’t taxed again. But the earnings — the growth that occurred over time — are taxable as ordinary income when you start withdrawing them. Choosing how to take those withdrawals can make a real difference in how much you pay in taxes and when.
Deciding Between Lump Sum or Periodic Payments
Beneficiaries have a few options for accessing funds from an inherited non-qualified annuity, and each comes with different tax consequences.
If you choose to receive a lump sum, all of the annuity’s earnings become taxable in the year you receive them. For many, this can mean jumping into a higher tax bracket, resulting in a larger-than-expected tax bill.
Meanwhile, you could opt for periodic payments over time. With this method, each payment you receive contains part principal (tax-free) and part earnings (taxable). By spreading out the income, you may stay in a lower tax bracket each year, which could reduce your overall tax burden.
Another option offered by some contracts is the five-year rule — all funds must be withdrawn within five years of the original owner’s death. This approach still spreads the taxable earnings across multiple years, offering some relief compared to taking everything at once.
Special Considerations for Spouses and Non-Spouse Beneficiaries
The tax story also depends on who you are in relation to the original owner.
If you’re the spouse, you have a unique advantage. You can elect to continue the annuity in your name, allowing earnings to keep growing tax-deferred until you choose to start withdrawals. This option can be especially valuable if you don’t need the money right away and prefer to postpone taxes.
For non-spouse beneficiaries, the choices are usually more limited: take a lump sum, withdraw the funds over a period not exceeding 10 years, or base withdrawals on your own life expectancy. Each option still requires you to start taking distributions, often beginning within a year of inheriting.
The Exclusion Ratio: How Taxes Are Calculated
How do you know which part of each payment is taxable? The IRS uses what’s called the exclusion ratio. This formula determines how much of each payment represents a tax-free return of principal versus taxable earnings.
For example, if the annuity was purchased for $50,000 and is expected to pay out $100,000 over its term, half (50%) of each payment would be tax-free, and the other half would be taxable. Your insurance company generally provides this calculation, and you’ll get an annual tax form (Form 1099-R) showing how much income to report.
Other Tax Traps and Fees to Watch Out For
While the tax rules are central, beneficiaries should also be aware of potential fees and penalties. If you take money out before age 59½, there’s typically a 10% early withdrawal penalty on the earnings portion, though this usually doesn’t apply when money is inherited.
Variable annuities, in particular, often come with high annual fees, including administrative costs and insurance charges, which can reduce overall returns. If you decide to surrender (cash in) the annuity early, surrender charges might also apply.
It’s also worth noting that the taxable earnings may be subject to an additional 3.8% net investment income tax if your income is above certain thresholds.
Why It’s Wise to Seek Expert Guidance
Taxation of inherited non-qualified annuities isn’t simple, and the decisions you make can have long-lasting financial impacts. Consulting a financial advisor or tax professional can help you choose the payout strategy that aligns with your financial goals and minimizes your tax liability.
Inherited annuities can be a useful part of your financial plan, but only if you understand the rules and plan carefully.