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Know your options if inheriting annuities

April 16, 2011

By Vince D'Amato, Ma, Chfc, Financial Planning, 244-5723.

April 16, 2011 1

I find that most beneficiaries are unfamiliar with their options once they have inherited annuities, life insurance or IRA and other various retirement accounts. Most people are usually very careful to make sure that their beneficiary designations are up to date, but are themselves unsure what happens to their account once they die.

Life insurance is usually the simplest of the group. Life insurance benefits are not subject to income tax (but can be subject to estate tax on a rare occasion). The proceeds of a life policy are almost always paid in a lump sum unless the policy owner-insured has made other distributions arrangements. The usual exception would involve minor children where the insured wants a large amount of cash held for a minor child until he or she is more mature and better able to handle a large sum of money.

Non-qualified annuities are in a world between life insurance and IRA accounts. Non-qualified (non-retirement) annuity owners will name a beneficiary like a life insurance contract. The parties in an annuity are the owner, the annuitant and the beneficiary. This is similar to a life insurance policy where the parties are the owner, the insured and the beneficiary. The death benefit is paid out of an annuity when the "annuitant" dies. The annuitant and the owner are usually the same person, but a trust can own an annuity and a trust never dies. The annuitant in an annuity contract and the insured in a life insurance policy are basically the same.

The beneficiaries of an annuity will have similar options to that of an IRA account. Each beneficiary can determine how he receives his inheritance, but he will have to complete the distribution within a five-year period following the year the annuitant died.

Non-qualified annuities will defer tax on the accumulated interest until withdrawn so that often the beneficiary will be responsible for the income tax that has yet to be paid.

Older annuity contracts can have a large accumulated amount of un-taxed earnings, so that a beneficiary may want to stagger the proceeds over the five-year period to minimize the impact of the taxes.

Usually, the taxable amounts are distributed first until all earnings are out of the contract. The remaining basis (original deposit) is not taxed to the beneficiary.

I mention this because individuals might want to determine their tax liability before making the choice to take a lump sum distribution from a non-qualified annuity.

Most non-qualified annuities have something called a "spousal continuance" that will allow a surviving spouse to take over the non-qualified annuity without a tax consequence. All other beneficiaries will be subject to the five-year distribution rule.

IRA accounts and most retirement accounts can be more complicated for a beneficiary. The one exception is a Roth IRA or any other Roth retirement account. The proceeds of a Roth are never taxed to any beneficiary.

Traditional IRAs will have the standard five-year distribution rule mentioned above. A beneficiary will also have something known as a "stretch IRA" option. This stretch option will have to be made by Dec. 31, following the year the IRA owner died.

Traditional IRAs are 100 percent taxable as long as the owner was able to take a tax deduction while contributing to the IRA. Each beneficiary can choose individually how he wants to receive the proceeds. The spouse has the option of inheriting the IRA proceeds without tax by basically transferring the IRA to her own IRA.

The "stretch IRA" generally will allow the non-spouse beneficiary to take the income from the beneficiary IRA over the beneficiary's life expectancy. This can dramatically reduce the income tax liability over several years and perhaps provide a larger net distribution. Individuals in the age 40 or so range could stretch the IRA income over 30 years or more.

Once the stretch option is selected there will be a "minimum distribution" amount set up for each year. Beneficiaries can always elect to take more than the required minimum distribution in any year, but they cannot take less (unless they are willing to pay a 50 percent penalty on the amount they were required to take). The 10 percent penalty for early IRA distributions (age 59Â½) is waived for these beneficiary IRA accounts.

I might mention the 10 percent penalty is always waived for any beneficiary younger than 59Â½ whether he chooses a lump sum, five-year distribution or a stretch IRA payout.

Any person named as a beneficiary of any type of account should take the time to understand the options before making a final decision. It might also be a good idea to consult a tax professional regarding these matters.

Vince D'Amato, MA, ChFC, financial planning, 244-5723.

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