Inheriting an Annuity? Here’s a Little-Known Way to Stretch Its Tax Benefits
There are a few different ways beneficiaries of annuities can claim their inheritance. One you might not have heard of is called an "annuity stretch." It gives non-spouse beneficiaries a way to receive income and defer taxes.
You are now subscribed
Your newsletter sign-up was successful
Want to add more newsletters?
Delivered daily
Kiplinger Today
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more delivered daily. Smart money moves start here.
Sent five days a week
Kiplinger A Step Ahead
Get practical help to make better financial decisions in your everyday life, from spending to savings on top deals.
Delivered daily
Kiplinger Closing Bell
Get today's biggest financial and investing headlines delivered to your inbox every day the U.S. stock market is open.
Sent twice a week
Kiplinger Adviser Intel
Financial pros across the country share best practices and fresh tactics to preserve and grow your wealth.
Delivered weekly
Kiplinger Tax Tips
Trim your federal and state tax bills with practical tax-planning and tax-cutting strategies.
Sent twice a week
Kiplinger Retirement Tips
Your twice-a-week guide to planning and enjoying a financially secure and richly rewarding retirement
Sent bimonthly.
Kiplinger Adviser Angle
Insights for advisers, wealth managers and other financial professionals.
Sent twice a week
Kiplinger Investing Weekly
Your twice-a-week roundup of promising stocks, funds, companies and industries you should consider, ones you should avoid, and why.
Sent weekly for six weeks
Kiplinger Invest for Retirement
Your step-by-step six-part series on how to invest for retirement, from devising a successful strategy to exactly which investments to choose.
One of the biggest advantages of an annuity, tax deferral, can be lost when anyone other than a spouse inherits an annuity. Then, all deferred taxes on the gains must be paid sooner or later. It’s usually better to pay them later rather than sooner — and there are different ways to do that.
If the beneficiaries take the proceeds as one lump sum or even distributions over a few years, they might get kicked into a higher tax bracket. For an annuity with a large untaxed gain, that could mean that a lot of the money would go to pay state and federal income taxes.
This is a problem only for non-spouse beneficiaries. A surviving spouse can usually just keep the annuity intact and continue to defer taxes.
From just $107.88 $24.99 for Kiplinger Personal Finance
Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Two Traditional Annuity Inheritance Routes
Fortunately, there is a little-known way for a non-spouse beneficiary to spread out payments and taxes, continue to benefit from tax deferral and thus ultimately receive more money. But first, here are the two main ways people have typically received annuity money:
The default is the five-year rule. Under it, the beneficiary or beneficiaries have five years to take out the proceeds of the annuity. They can take them out gradually or in a single lump sum anytime up until the fifth anniversary of the owner’s death.
But even a series of five equal distributions has tax drawbacks. An annuity normally includes both gains and non-taxable principal. Unfortunately, gains are distributed first. So, for instance, if the annuity has $50,000 in gains and $50,000 in principal, you won’t receive the tax-free principal until after you’ve received all of the gains.
The second method is annuitization. Here, the beneficiary directs the insurer to annuitize the proceeds and turn the money into a stream of income — for either a set period of time or a lifetime.
Besides guaranteed monthly income, another advantage is partial tax deferment. Each payment includes both taxable gains and non-taxable return of premium — the exclusion amount. Annuitization can be a great choice, but you give up flexibility. Once you’ve annuitized, there’s no cash value. You’ve given up the money in exchange for long-term income.
Enter the Annuity Stretch
Aside from the five-year rule and annuitization, the newest way people can receive annuity money is called a non-qualified annuity stretch. Non-qualified means the annuity is not held in an IRA or another type of qualified retirement account. It’s an underused planning tool, but more insurance companies are offering this option now.
The stretch method is a bit more complex but worth considering. Here, the beneficiary receives monthly, quarterly or annual payments based on his or her life expectancy. If there are multiple beneficiaries, each one is free to choose his or her own method.
Since the payments are spread out, annual income tax bills are smaller. And the additional taxable income is less likely to push the recipient into a higher tax bracket than a lump-sum. The money remaining in the annuity continues to grow tax-deferred.
Flexibility is another plus. The beneficiary can cancel payments at any time and receive whatever’s left as a lump sum.
What happens if the beneficiary dies prematurely? For example, suppose the beneficiary’s life expectancy was 20 years, but he or she dies after just 10 years. A successor beneficiary (such as the grandchild of the original owner) can receive the balance of remaining payments. This is a unique advantage of the stretch option.
The Bottom Line
No one distribution method is best for everyone. You need to consider your tax situation and financial needs and compare options before you decide.
Non-spousal beneficiaries have one year from the death of the annuity owner to set up the stretch distribution. Only natural persons (not trusts or charities) can choose the stretch option.
-
5 Vince Lombardi Quotes Retirees Should Live ByThe iconic football coach's philosophy can help retirees win at the game of life.
-
The $200,000 Olympic 'Pension' is a Retirement Game-Changer for Team USAThe donation by financier Ross Stevens is meant to be a "retirement program" for Team USA Olympic and Paralympic athletes.
-
10 Cheapest Places to Live in ColoradoProperty Tax Looking for a cozy cabin near the slopes? These Colorado counties combine reasonable house prices with the state's lowest property tax bills.
-
Don't Bury Your Kids in Taxes: How to Position Your Investments to Help Create More Wealth for ThemTo minimize your heirs' tax burden, focus on aligning your investment account types and assets with your estate plan, and pay attention to the impact of RMDs.
-
Are You 'Too Old' to Benefit From an Annuity?Probably not, even if you're in your 70s or 80s, but it depends on your circumstances and the kind of annuity you're considering.
-
In Your 50s and Seeing Retirement in the Distance? What You Do Now Can Make a Significant ImpactThis is the perfect time to assess whether your retirement planning is on track and determine what steps you need to take if it's not.
-
Your Retirement Isn't Set in Stone, But It Can Be a Work of ArtSetting and forgetting your retirement plan will make it hard to cope with life's challenges. Instead, consider redrawing and refining your plan as you go.
-
For the 2% Club, the Guardrails Approach and the 4% Rule Do Not Work: Here's What Works InsteadFor retirees with a pension, traditional withdrawal rules could be too restrictive. You need a tailored income plan that is much more flexible and realistic.
-
Retiring Next Year? Now Is the Time to Start Designing What Your Retirement Will Look LikeThis is when you should be shifting your focus from growing your portfolio to designing an income and tax strategy that aligns your resources with your purpose.
-
I'm a Financial Planner: This Layered Approach for Your Retirement Money Can Help Lower Your StressTo be confident about retirement, consider building a safety net by dividing assets into distinct layers and establishing a regular review process. Here's how.
-
The 4 Estate Planning Documents Every High-Net-Worth Family Needs (Not Just a Will)The key to successful estate planning for HNW families isn't just drafting these four documents, but ensuring they're current and immediately accessible.
