Inheriting Non-Qualified and IRA Annuities

So, let’s say that you have inherited an annuity. Would you know where to start? If you are wondering what is the best thing to do with an inherited annuity, this post is definitely for you. If those shoes do not fit today, read along anyway and learn the important lessons of who, what, when, where, and why of the retirement annuity inheritance story.

Who is the “who” in an annuity inheritance story? Of course to start, there is the insurance company and the representative selling the policy. On the client side of things there are a few roles, and while they can be played by separate actors, sometimes these roles are just different hats worn by the same person. In insurance jargon, the annuitant is the person whose lifespan the policy is based on. In many retirement annuities, this person is also the owner of the policy, but not always. This annuitant and likely owner may be your spouse, uncle, mother, father, or really anyone who may have loved you (or at least wants you to fill out a lot of paperwork before you get any of their cash). The beneficiary is the final role, and for the sake of simplicity we will assume that is you.

It is important to note that, in a basic annuity policy, when the annuitant dies it is the policy that changes hands: the beneficiary becomes the new owner, unlike with life insurance where a benefit is simply paid out. In addition to the more obvious benefits like a cash value, the policy can have contractual benefits with options around interest rate guarantees and income withdrawal benefits that are more nuanced. You should take the time to review each benefit that is available to you, not just the cash value.

The best first thing to do with an inherited annuity is to analyze it. Start the analysis by looking at the facts and circumstances so you can begin unpacking the jargon and chart a clear path forward. Every annuity policy can be unique, and the contract rules. I am going over general advice today, but talk through these questions with your advisor: What are the specifics of the policy, and what is your relationship to the annuitant?

If you are a beneficiary of a policy from a spouse who was receiving income at least annually, it is likely that this annuity was used as part of a retirement income strategy. Often these annuity policies are bought inside of individual retirement arrangements (IRAs) with money rolled over from 401(k) plans or other employer-sponsored retirement plans. If that is the case for you, you should work with your insurance company and a trusted financial service fiduciary to review the rights that a spousal beneficiary has under the policy. Unlike Social Security benefits, which typically decrease at the death of the first person in a married couple, most of the annuity policies I run into that are purchased by a married or life-partnered annuitant have guaranteed income benefits that are “level” and “joint” that keep payments at the same rate. The best course of action in this scenario is usually to keep the ongoing annuity payments in place (with little to no paperwork required at the insurance carrier), but consult your tax advisor for recommendations regarding retitling the IRA.

If you are a non-spousal beneficiary of an IRA annuity, you will have fewer options to choose from. Annuities are often useful tools for retirees but can create headaches for younger beneficiaries who will have to work through the contract details on top of understanding the new Secure Act 2.0 tax laws. The non-spousal beneficiaries that we help tend to be the siblings and kids of the deceased annuitant. These beneficiaries inherit someone else’s annuity, and, like many hand-me-downs, the fit can be a bit (or a lot) wrong on the next in line. Thankfully, when an annuity is inherited inside of a retirement account most people can simplify their lives by substituting the annuity for other investments that fit better.

Not all inherited annuities are held inside a retirement plan. Higher-net worth families and individuals will often purchase an annuity outside of retirement accounts to defer taxes within the lifetime of the annuitant. Similar to with IRA annuities, if you are a spouse inheriting a non-retirement plan annuity (a “non-qualified” annuity), you typically will have better options than a non-spouse, both in the contract and under tax law.

When you inherit an annuity, you might have conflicting priorities. You might be tempted by a lump sum payout but want to avoid paying taxes on your new inheritance, which is often the case when we have a non-spouse beneficiary listed on a large annuity policy, or you might want to exercise the option available to certain beneficiaries to continue income benefits.

When an annuity policy is inside a retirement plan, the taxes are going to be classified the same way for both spousal and non-spousal beneficiaries. When a distribution comes out of a retirement plan, it is taxed like any other distribution funded by selling a stock or bond inside a retirement plan – it does not matter that it was an annuity because to the IRS it is just a retirement plan distribution. The big difference is driven by how quickly you must draw down the cash value of the annuity, and therefore how much income you are receiving from the annuity each year. Whether limited to a ten-year period for non-spouses (the “10-Year Rule”) or spread over a widow or widower’s lifetime, taxes for these distributions can be managed through IRA withholding with a well-structured withdrawal strategy.

However, if you are the beneficiary of a non-qualified annuity (one that is not in a retirement plan like an IRA that qualifies for special tax treatment), you will want to get professional help to minimize the technicalities-induced headaches coming your way, spousal inheritance or not. Working with a professional who has experience with non-qualified annuities can make the difference when discussing the hoop-jumping involved with tax-deferred 1035 transfers and the potential speed bumps around LIFO (last in, first out) taxation versus annuitized tax treatment (more on that below).

At the policy level, unless your new-to-you annuity’s provisions fit you like a glove, you should consider utilizing a 1035 transfer. With a 1035 transfer, you can exchange your uncle’s old annuity for a new annuity policy tailored to your needs. The 1035 language allows you to fully distribute the value from one annuity contract and use another annuity to receive the funds in an “exchange” that will not be taxable. Taxes would instead be based on the future distributions from the new policy when they occur. Often, we use “investment-only” variable annuities for non-spousal beneficiaries who are interested in maximizing their tax deferral while also seeking higher returns & future cash flow. These have no commissions nor surrender charges and can offer index funds as well as actively-managed portfolios.

Know that there are no wiser words said of annuities and 1035 transfers than “measure twice, 1035 once” because there often is no way to reverse some of these exchanges. Pick a team of professionals that can guide you through all the intricacies of retirement income planning and inheritance management, or just call me.

Doug “Buddy” Amis, CFP®