If you’re the surviving spouse

As a surviving spouse, you typically have the most flexibility and favorable options:

• Continue the annuity as your own: This is often the most advantageous option. You can essentially step into your deceased spouse’s shoes and continue the annuity contract as if you were the original owner. The money continues to grow tax-deferred, and you won’t face distribution requirements until you decide to take withdrawals or reach certain ages (depending on the annuity type).

• Receive payments over your life expectancy: You can choose to receive the annuity value in payments stretched over your remaining life expectancy, which can minimize the annual tax burden and allow the remaining balance to continue growing tax-deferred.

• Take a lump sum: You can cash out the entire annuity at once, though this typically creates a significant tax liability and is usually the least tax-efficient option.

• Five-year rule: Some annuities allow you to withdraw the entire balance within five years of the original owner’s death, giving you more flexibility than an immediate lump sum while still accessing the funds relatively quickly.

The ability to continue the annuity as your own is a significant advantage that only spouses have. It allows you to defer taxes the longest and treat the annuity as if you’d owned it all along.

If you’re a non-spouse beneficiary

Non-spouse beneficiaries—including children, other relatives, friends, or trusts—face more restrictive rules and typically must begin taking distributions more quickly:

• Lump sum distribution: You can take the entire annuity value at once. While this gives you immediate access to the funds, it also creates immediate tax liability on all the growth in the annuity.

• Five-year rule: You must withdraw the entire annuity balance within five years of the owner’s death. You can take distributions in any amount and frequency during this period, but the account must be completely emptied by the end of the fifth year.

• Life expectancy method (stretch option): If the annuity contract allows it, you may be able to “stretch” distributions over your life expectancy. This was once widely available but has been significantly restricted by the SECURE Act of 2019 for certain inherited retirement accounts. However, the rules for non-qualified annuities (those not held in retirement accounts) may differ. You’ll need to check the specific contract terms and consult with a tax professional.

• Ten-year rule: Under the SECURE Act, some beneficiaries of inherited retirement accounts must withdraw the entire balance within ten years. If the annuity is held within an IRA or other qualified retirement account, these rules may apply.

The specific options available to you will depend on the annuity contract’s terms, whether the annuity is qualified or non-qualified, and when the original owner died.

Qualified annuities

A qualified annuity is held within a tax-advantaged retirement account such as an IRA, 401(k), or other qualified plan. The original owner funded this annuity with pre-tax dollars, meaning they received a tax deduction for their contributions.

Tax implications: When you inherit a qualified annuity, you’ll pay ordinary income tax on all distributions. The entire amount—both the original contributions and the growth—is taxable because the original owner never paid taxes on that money.

Distribution requirements: Qualified annuities are subject to the Required Minimum Distribution (RMD) rules that apply to inherited retirement accounts. The SECURE Act of 2019 significantly changed these rules:

• Spouses still have the most flexibility and can treat the inherited annuity as their own
• Most non-spouse beneficiaries must now withdraw the entire balance within ten years (the “10-Year Rule”)
• Certain “eligible designated beneficiaries” (minor children until they reach majority, disabled or chronically ill individuals, and beneficiaries less than ten years younger than the deceased) can still stretch distributions over their life expectancy

Non-qualified annuities

A non-qualified annuity was purchased with after-tax dollars outside of a retirement account. The original owner didn’t receive a tax deduction for their contributions.

Tax implications: With non-qualified annuities, you’ll only pay ordinary income tax on the earnings portion of the distributions, not on the return of the original owner’s contributions (the “basis”). This is calculated using an “exclusion ratio” that determines what percentage of each payment represents taxable earnings versus non-taxable return of principal.

If you take a lump sum distribution, all the earnings are taxed first before you receive any tax-free return of principal. This “earnings-first” rule can create a larger immediate tax burden.

Distribution requirements: Non-qualified annuities generally have more flexible distribution options and aren’t subject to the same RMD rules as qualified accounts. However, the insurance company’s contract will specify what options are available to beneficiaries.

Tax consequences

Understanding the tax implications of an inherited annuity is crucial because taxes can significantly reduce the actual benefit you receive.

• Income tax on distributions: Whether you inherit a qualified or non-qualified annuity, you’ll owe ordinary income tax on at least some portion of the distributions. This is critical to understand: annuity earnings are never taxed at the lower capital gains rate. They’re always taxed as ordinary income, which could be as high as 37% at the federal level, plus state income taxes.

• No step-up in basis: Unlike stocks, real estate, and many other inherited assets, annuities do not receive a step-up in basis at death. This means the built-in gains in the annuity remain taxable to you as the beneficiary.

• Estate taxes: While estate taxes don’t apply to most estates, if the deceased person had a very large estate, the annuity’s value could be subject to estate tax before you even receive it. The annuity would be included in the deceased’s gross estate at its date-of-death value. If estate taxes apply, they’re paid by the estate, not by you as the beneficiary. However, this could reduce the overall inheritance if the estate lacks sufficient liquidity to pay the taxes.

• Penalty-free withdrawals: One positive aspect of inheriting an annuity is that beneficiaries typically don’t face the 10% early withdrawal penalty that applies when living annuity owners take distributions before age 59½. Death of the owner is generally an exception to the penalty, allowing beneficiaries of any age to access the funds without this additional cost.

Surrender charges

Many annuities have surrender periods—typically lasting 5 to 10 years from purchase—during which withdrawals above a certain percentage (often 10% annually) trigger surrender charges. These charges can be substantial, sometimes starting at 7-10% in early years and declining over time. If the deceased purchased the annuity relatively recently, the surrender period may still be in effect. As a beneficiary, you might face surrender charges if you want to cash out the annuity quickly.

Important: Some annuity contracts waive surrender charges upon the owner’s death, but this is not universal. Carefully review the contract or speak with the insurance company to understand whether surrender charges will apply to your distributions.

Ongoing fees

If you’re continuing the annuity rather than taking a lump sum, be aware of the ongoing fees you’ll be paying. These can include:

• Mortality and expense risk charges: Annual fees (typically 1-1.5% of the account value) charged by the insurance company
• Administrative fees: Annual fees for recordkeeping and other services
• Underlying investment fees: For variable annuities, fees charged by the investment options (similar to mutual fund expense ratios)
• Rider fees: Additional charges for optional features like guaranteed minimum income benefits or enhanced death benefits

These fees can significantly erode returns over time, sometimes totaling 2-3% annually or more. Consider whether the annuity’s benefits justify these costs or whether you’d be better off taking a distribution and investing elsewhere.

Steps to take when you inherit an annuity

Inheriting an annuity requires prompt action and careful decision-making. Here’s what you need to do:

Notify the insurance company

Contact the insurance company as soon as possible to report the death. You’ll typically need to provide:

• A certified copy of the death certificate
• Proof of your identity as beneficiary
• Completed claim forms provided by the insurance company

Most insurance companies require notification within a specific timeframe (often 30-60 days), though failure to notify immediately usually doesn’t forfeit your rights—it just delays the process.

Obtain and review the contract

Request a complete copy of the annuity contract if the deceased’s records don’t include it. Read it carefully or have a financial advisor review it to understand:

• The exact type of annuity
• The current account value
• The basis (amount of after-tax contributions for non-qualified annuities)
• Available distribution options for beneficiaries
• Any surrender charges that apply
• Required distribution timelines
• Any special provisions or riders

Understand your distribution options

Based on the contract terms and your beneficiary status (spouse vs. non-spouse), determine what distribution options are available to you. The insurance company should provide a detailed explanation of your choices.

Consider the tax implications

Before making any decisions, consult with a tax professional to understand the tax consequences of each option. Calculate:

• The tax liability of a lump sum distribution
• The annual tax burden of stretched payments
• How the distributions will affect your overall tax bracket
• Whether state taxes apply

Evaluate your financial situation and goals

Consider your current financial needs and goals:

• Do you need the money immediately or can you defer distributions?
• Do you have high-interest debt that should be paid off?
• Would the guaranteed income from annuity payments benefit your financial plan?
• Can you achieve better returns by taking a distribution and investing elsewhere?
• What are the opportunity costs of leaving money in the annuity versus using it for other purposes?

Make your decision and submit required forms

Once you’ve evaluated your options, complete the necessary beneficiary claim forms and distribution election forms. Be aware that some elections are irrevocable, so make sure you’re confident in your decision before submitting paperwork.

Report and pay taxes

You’ll receive Form 1099-R from the insurance company reporting any distributions you receive. This income must be reported on your tax return. Consider whether you need to make estimated tax payments to avoid underpayment penalties if the distributions are substantial.

Common mistakes to avoid

Inheriting an annuity involves complex decisions, and mistakes can be costly. Here are pitfalls to avoid:

• Taking a lump sum without considering alternatives: The immediate availability of a large sum of money can be tempting, but cashing out an annuity in one lump sum often creates the largest possible tax liability. The entire gain will be taxed in a single year, potentially pushing you into a much higher tax bracket.

• Missing distribution deadlines: Some annuity contracts and IRS rules impose strict deadlines for beginning distributions or making beneficiary elections. Missing these deadlines can limit your options or force you into the least favorable distribution method.

• Ignoring surrender charges: If you need to access a large portion of the annuity and surrender charges apply, you could lose a significant percentage of the inheritance to fees.

• Failing to update your own estate plan: If you inherit an annuity and decide to continue it, remember to name your own beneficiaries. If you fail to do so and you die, the annuity will pass according to the contract’s default provisions, which might not align with your wishes.

• Not seeking professional advice: Annuities are complex financial products, and the rules governing inherited annuities involve intricate tax law and contract provisions. Making decisions without professional guidance can result in costly mistakes.

• Assuming all annuities are the same: Annuities vary enormously in their terms, quality, and costs. Some are excellent financial products with low fees and favorable terms, while others are expensive and provide limited value.

Planning for the future: Lessons for your own estate planning

If you’re going through the process of inheriting an annuity, you’re likely learning that you don’t want to leave your own beneficiaries with the same complexity and confusion. Here are lessons to apply to your own estate planning:

• Choose beneficiaries carefully: Name specific individuals as beneficiaries rather than your estate. This allows the annuity to pass directly to beneficiaries outside of probate and typically provides them with more favorable options.

• Name contingent beneficiaries: If your primary beneficiary predeceases you, a contingent beneficiary ensures the annuity passes according to your wishes rather than the contract’s default provisions.

• Consider the tax situation: Think about which beneficiaries are in the best position from a tax perspective to inherit the annuity. A beneficiary in a low tax bracket might benefit more than one in a high bracket.

• Communicate your intent: Let your beneficiaries know about the annuity, where to find the paperwork, and your reasoning for choosing an annuity as part of your estate plan. This helps them make informed decisions when the time comes.

• Review and update regularly: Life circumstances change. Review your beneficiary designations every few years and after major life events (marriages, divorces, births, deaths) to ensure they still reflect your wishes.

• Consider whether an annuity is the right tool: Annuities can be valuable for providing guaranteed income during your lifetime, but they’re often not the most tax-efficient asset to leave to heirs. Consider whether other assets might serve your estate planning goals better.

Final thoughts

Inheriting an annuity is far more complicated than inheriting most other assets. Your relationship to the deceased, the type of annuity, whether it’s held in a qualified account, the contract’s specific terms, and your own financial situation all interact to determine your best course of action.

Take your time to understand your options, run the numbers on different scenarios, and make an informed decision rather than a reactive one. An inherited annuity can be a valuable financial asset if handled correctly, or it can become a source of unnecessary taxation and complexity if managed poorly.

Pave the way with Stone Street

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• Annuity
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If so, we will work with you one-on-one so you get the options that best fit your needs:

• One-on-one consultation.
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Call us at 866-416-5118 to talk about your financial needs and what annuity payments you have coming to you. We’ll do the hard work and handle the rest of the process!