How to Minimize Paying Taxes on an Inherited Annuity

Annuities are often included in estate plans, and how they’re taxed depends on their structure and your choices as a beneficiary. If the annuity is not a “joint and survivor” annuity and no beneficiary is named, remaining funds might be lost to the institution that holds the contract.

The tax treatment of an inherited annuity hinges on whether it’s qualified or non-qualified. Qualified annuities, funded with pre-tax dollars, are fully taxable upon distribution and subject to required minimum distribution (RMD) rules. However, only the earnings portion of distributions from non-qualified annuities are taxed since they’re funded with after-tax dollars.

Beneficiary Options and Tax Strategies

As a spousal beneficiary, you can continue the annuity’s payment schedule, deferring taxes until you receive distributions. Non-spouse beneficiaries, such as children, face ordinary income taxes on distributions, with often some or all of the following options for receiving payouts:

Lump sum: Receive all funds at once, paying taxes immediately.

Five-year rule: Spread payments and tax liability over five years.

Non-qualified stretch: Extend payments over your lifetime, based on life expectancy.

Periodic payout: Receive payments for a certain time frame not based on life expectancy.

Minimizing Tax Burden

While taxes on inherited annuities are inevitable, there are ways to manage their impact. Exercising your option to continue receiving payments as usual if you’re a surviving spouse is one way to maintain the tax-deferred status of an inherited annuity. Similarly, you can lower your tax exposure by opting for non-qualified stretch payments based on your life expectancy or periodic payments if you’re inheriting an annuity as a non-spouse.

You can also do a 1035 exchange and swap the annuity for a similar product but one with more favorable terms or benefits.

Lastly, you can do an IRA rollover if you also inherited the deceased annuitant’s IRA. However, you can only roll over an inherited annuity to an inherited IRA if the annuity funds are qualified. You’d then be subject to inherited IRA tax rules. Inheriting an annuity? Explore your options. Click here to begin.