Inherited Annuities

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When searching for investments that provide a guaranteed stream of income, annuities are often the top choice. Paid out in a lump sum or as monthly payments, an annuity can help investors enjoy a worry-free retirement or help take care of a loved one.

Most annuities are owned by a single individual, but adding a rider allows a spouse to become the owner if the original owner passes away.

Naturally, it’s a bittersweet situation to inherit an annuity. However, you should remember that your loved one purchased an annuity to ensure a comfortable life for both of you, no matter the circumstances.

Read this article to understand an inherited annuity better, the options a surviving spouse can have, the benefits, and the tax implications.

What Is Inherited Annuity?

An annuity is a long-term investment offered by insurance companies. It guarantees you a stream of income for life in exchange for a lump sum of money or monthly premiums that you invest for a defined period of time.

An inherited annuity is the same contract that is passed down to a surviving spouse or another beneficiary after the original annuity owner passes away.

While some annuities cease paying after the owner's death, other annuities include a death benefit, continuing the payments to a beneficiary.

Key Takeaways

An inherited annuity is a financial product that is passed down to a beneficiary after the annuity owner’s death.
A beneficiary can be a spouse or any other person who will receive a lump sum payment, installments, or lifetime income.
Inherited annuities can be qualified (fully taxable) or non-qualified (only earnings are taxed).

How Does Inheriting an Annuity Work?

To inherit an annuity as a spouse or other family member, one should be included in the contract. Since traditional annuities cease payments immediately after the owner’s death, it’s important that a contract specifies a beneficiary.

For an annuity to be inherited, the contract must include a rider, such as a death benefit or spousal continuation option. Only the annuities with these riders activate the inheritance process.

Payment options and other important details are also clearly outlined in the annuity contract. To ensure you have accurate information about your annuity inheritance, always refer directly to the terms of your contract.

Inherited Annuity Rules

When inheriting an annuity, the way you receive it and what you can do with it in the future depend on whether you are a spouse or a family member. Here is what you need to know:

For the Surviving Spouse

Regardless of what variable your annuity has, a surviving spouse will always receive guaranteed lifetime payments. In fact, surviving spouses can also treat the annuities as their own and receive the benefits outlined in the contract.

For Other Beneficiaries

If you are not a surviving spouse but a family member or any other person, the inherited annuity rules differ. Upon the death of an annuity owner, you will have three following options:

Receive a one-time lump sum payment
Have the remaining annuity amount paid to you over a period of 5 years
Receive the full amount over your lifetime

The good news is that you are not immediately faced with the choice–you will have 60 days given to you to make a decision.

Here are a few things to keep in mind:

If the annuity owner passes away while taking the payments, you should continue receiving them at the same rate.
When you inherit an annuity, its gains remain with the policy.
The taxes depend on how payments are made.

Death Benefit Option

Most annuity products offer a death benefit, meaning you don’t have to purchase an additional rider in order to support your loved one after you pass away.

Before you finalize an annuity contract, make sure to research the three death benefits options to ensure you choose the suitable one for your loved one:

Standard death benefit

This option is usually included for free in the annuity because it pays at least the amount already contributed to the annuity (minus the fees and withdrawals).
Guaranteed increase death benefit

This option works much like a standard death benefit with one exception. It increases the payout by a small percentage annually.
Annuity death benefit rider

This rider is added for an extra fee and offers a better payout compared to other options. In addition to an increased amount, the rider provides protection against market downturns.

Make sure you check your contract and choose the death benefit option that works best for you and your loved one.

Inherited Annuity Distribution Rules

You can inherit annuity payouts either all at once or spread over time.

If you go for a lump sum payout, prepare to give a portion of it to taxes. If you opt for another option, it may take years to claim all the money, but at least you will benefit from a lower tax.

Lump Sum Payment

With an inherited annuity, you can receive the remaining funds in one big payment. Although you will immediately have access to the money, you should consider the tax that will be applied to your payout.

Roll Over Annuity

In some cases, you might be able to roll your inherited annuity into another retirement account. This way, you will be able to claim all the money without paying any taxes on the transferred amount.

Spouses usually have the most options and can withdraw the fund for the rest of their lives, while other beneficiaries will need to deplete the full amount form their retirement plan within 10 years.

Spread Over Time

Finally, you can have the remaining balance paid to you over life, ensuring a lifelong stream of income. By opting for installments, you also reduce the tax so that you won’t owe taxes on the entire annuity at once.

In addition to that, you won’t be subject to the 10% early withdrawal penalty if you’re under the age of 59 ½.

Benefits of an Interited Annuity Contract

Whether it is worth getting an annuity with a death benefit or a Surviving Spouse rider is totally up to you. But if you are looking for ways to ensure a stable financial future for your loved one, here is why you should consider this investment:

Additional Income Stream: Any beneficiary can benefit from a prolonged or even lifelong stream of income, further enhancing financial stability.
Spousal Advantages: Spouses who inherit an annuity can roll it into their own account, defer taxes, and continue the contract under favorable terms, including lifetime withdrawals.
Ability to Pass Assets to Your Heirs: You can choose your beneficiaries, ensuring that your inheritance will support your loved ones.

Tax Implications of an Inherited Annuity

Figuring out inherited annuity taxes can be tricky, but we will try to explain them in simple terms.

Non-Qualified Annuities: These are the annuities funded with after-tax dollars so that a beneficiary won’t owe taxes on the original contributions. However, earnings in the account will be taxed.
Qualified Annuities (like IRAs or 401(k)s): These annuities are funded with pre-tax dollars, meaning a beneficiary will owe regular income tax on the entire amount withdrawn. The tax will apply to the original investment and earnings. Surviving spouses can roll the funds into their own IRA and delay taxes on withdrawals.

Regardless of what kind of annuity you have, you will file a Form 1099-R showing how much tax you owe.

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FREQUENTLY ASKED QUESTIONS

How can I protect my annuity in a divorce?

If you want to protect your annuity in a divorce, you should consider a prenuptial or postnuptial agreement. This agreement will outline how the annuity will be handled–otherwise, the court may decide to divide the annuity based on whether it’s marital or separate property. Make sure to consult with a financial advisor or an attorney beforehand.

Do I have to pay taxes on an inherited annuity?

Yes, taxes may apply to an inherited annuity, depending on whether it’s a qualified or non-qualified annuity.

For non-qualified annuities, you’ll pay income tax on the earnings but not the principal, as it was funded with after-tax dollars.

For qualified annuities, the entire withdrawal amount is typically taxed as ordinary income because it was funded with pre-tax dollars.

What happens to my annuity after death?

If you have a beneficiary, they should receive the remaining balance of your annuity or a death benefit.

If you don’t have a beneficiary, the annuity money will either revert to the insurance company or become part of the estate.

The Bottom Line

Inherited annuities can provide financial stability and flexibility for your loved ones, offering options to continue payments, defer taxes, or pass the assets to heirs.

Whether you're considering purchasing an annuity or navigating an inheritance, it’s important to understand the contract's terms, tax implications, and distribution options. Only when you have all the information you can make an informed decision.

At Annuity Association, we have helped many people find suitable annuity products that can ensure financial security for themselves and their families.

Take our Annuity Quiz or get in touch with one of our advisors to discuss your retirement options!

Annuity Expert

Jeremiah Konger

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