Inherited Annuity and Beneficiary Payout Options
What happens to your annuity payments after you die depends on the type of annuity you own and its payout plan. Some annuities feature death benefits that allow the owner to select a beneficiary to inherit remaining funds. Inherited annuity payouts may follow different tax rules.
- The original annuity contract holder must include a death benefit provision and name a beneficiary.
- There are different tax consequences for spouses vs non-spouse beneficiaries. Any beneficiary can choose to take a one-time lump-sum payout, however, this comes with a heavy tax burden.
- Annuity beneficiaries are not limited to people. You can also select a nonprofit organization or a trust established as part of your estate plan.
What Happens to an Annuity If You Die?
Some annuities can be passed on to a beneficiary after you die. This death benefit allows the person you select to inherit remaining payouts from the insurance company.
However, not all types of annuities include a death benefit, or it may be limited. This provision must be written into the contract you signed with the insurance company.
Different annuities have different payout options.
- Fixed-Period Annuity
- A fixed-period, or period-certain, annuity ensures payments to you for a specific length of time. For example, payments may last 10, 15 or 20 years. If you pass away during this time, your selected beneficiary receives any remaining payouts.
- Life Annuity
- As the name suggests, a life annuity guarantees you payments for the rest of your life. This type of annuity may not pay any survivor benefits. However, if the annuity is still in the accumulation phase and you haven’t started receiving payments, some contracts allow you to include a death benefit for your beneficiary.
- Joint Life
- A joint life or survivor annuity guarantees lifetime payments for you and your spouse. If you die, your survivor continues to receive money. If both spouses die early, some contracts allow a third beneficiary to receive payments.
- For variable annuities beneficiaries usually receive at least the original amount the owner contributed.
How Does an Inherited Annuity Work?
To receive an inherited annuity, your contract must include a death benefit provision and name a beneficiary.
Otherwise, payments will stop when you die, or the insurance company will keep any future payments.
If your contract includes a death benefit, remaining annuity payments are paid out to your beneficiary in either a lump sum or a series of payments.
You can choose one person to receive all the available funds or several people to receive a percentage of remaining funds.
You can also select a nonprofit organization as your beneficiary, or a trust established as part of your estate plan.
If you have inherited your spouse’s annuity, you can choose to transfer the annuity contract into your name.
Doing so allows you to keep the same options as the original owner, including the annuity’s tax-deferred status.
You will also be able to receive remaining funds as a stream of payments instead of a lump sum.
Non-spouses can also inherit annuity payments. However, they cannot change the terms of the contract and will only have access to the designated funds outlined in the original annuity agreement.
There are three main ways beneficiaries can receive inherited annuity payments.
- Lump-Sum Distribution
- A lump-sum distribution allows the beneficiary to receive the contract’s entire remaining value as a single payment.
- Nonqualified-Stretch Provision
- This annuity contract clause allows a beneficiary to receive payments for the rest of his or her life.
- Five-Year Rule
- The five-year rule allows beneficiaries to spread withdrawals over a five-year period or withdraw all remaining funds during the fifth year.
Tax Consequences of Inherited Annuities
Different tax consequences exist for spouse versus non-spouse beneficiaries.
Surviving spouses can change the original contract into their own name. This allows partners to enjoy the same tax-deferred benefits as the original annuity owner.
Any beneficiary — including spouses — can choose to take a one-time lump sum payout. In this case, taxes are owed on the entire difference between what the original owner paid for the annuity and the death benefit. The lump sum is taxed at ordinary income tax rates.
Lump sum payouts carry the highest tax burden. The sudden influx of money may also push you into a higher tax bracket and further increase how much money you owe in taxes.
Spreading payments out over a longer time period is one way to avoid a big tax bite.
For example, if you make withdrawals over a five-year period, you will owe taxes only on the increased value of the portion that is withdrawn in that year. It is also less likely to push you into a much higher tax bracket.
A final option is spreading payments out over the beneficiary’s lifetime. This offers the least tax exposure but also takes the longest time to receive all the money.
If you’ve inherited an annuity, you often must make a decision about your death benefit quickly. Decisions about how you want to receive the money are often final and can’t be changed later.
Understanding your options is essential in order to make the best choice for your situation.
8 Cited Research Articles
- Internal Revenue Service. (2020, February 12). Publication 575 Pension and Annuity Income. Retrieved from https://www.irs.gov/publications/p575#en_US_2016_publink1000226982
- Internal Revenue Service. (2020, January 8). Retirement Topics - Beneficiary. Retrieved from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
- Lake, R. (2020, January 8). What Happens to an Annuity When You Die? Retrieved from https://finance.yahoo.com/news/happens-annuity-die-234955255.html
- U.S. Securities and Exchange Commission. (2018, October 30). Updated Investor Bulletin: Variable Annuities. Retrieved from https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_variableannuities#The_Death
- Haithcock, S. (2014, June 24). Some annuities are to die for. Retrieved from https://www.marketwatch.com/story/some-annuities-are-to-die-for-2014-06-24
- Arizona State Retirement System. (n.d.). Retirement Annuity Options. Retrieved from https://www.azasrs.gov/content/retirement-annuity-options
- Bouman, T. (n.d.). Annuities - Bouman Law Firm. Retrieved from https://www.tomboumanlaw.com/annuities.html
- CNN Money. (n.d.). What happens to my annuity after I die? Retrieved from https://money.cnn.com/retirement/guide/annuities_basics.moneymag/index12.htm