04.18.18
Making Annuity Inheritances more Tax-Efficient
by: AXA Distributors, Laird Johnson
Consider a 1035 exchange to Investment Edge, then “stretch” the annuity.
When an individual inherits a non-qualified deferred annuity, they will end up paying taxes on the money they receive. Without proper planning, income taxes can deplete a good chunk of those assets, unless the beneficiary understands the potential distribution options available. By choosing the right option, the beneficiary may be able to control when and how much is paid in taxes.
The non-spouse beneficiary who has inherited a non-qualified annuity can typically choose from the following distribution options:
- Lump sum distribution — Get it all at once and pay all the taxes immediately.
- Defer distributions for up to five years — All of the interest in the contract must be distributed by the fifth anniversary of the owner’s death.
- Annuitization — Receive payments over the beneficiary’s lifetime or for a specific period of time.
- “Stretch” the distributions over the beneficiary’s lifetime using the individual’s single-life expectancy provided the contract permits.
- Spouses may also have the option to continue the annuity contract in their own name.
The “stretch” option allows the beneficiary to control when they pay taxes. If the non-spousal beneficiary does not need the income from the annuity contract, the individual can “stretch” distributions over their life expectancy. These distributions must begin within one year of the owner’s death and will be based on the individual single, non-recalculated life expectancy.
Choosing the “stretch” option may let the beneficiary control when they have to pay taxes on distributions. Instead of liquidating the contract in a lump sum and paying all the taxes in one year, stretching the contract spreads the tax liability out over several years. When the “stretch” option is chosen, distributions are taxed on a last-in-first-out (LIFO) basis. That means, all earnings from the annuity are distributed before the basis (principal) in the contract. Amounts that are not withdrawn from the annuity remain invested and will continue to grow tax deferred under the investment control of the inheriting beneficiary.
What if your inherited annuity doesn’t fit your needs?
One of the challenges that the beneficiary of a non-qualified annuity may run into is the limitations of the annuity contract; the annuity may not meet their current investment or income goals. The features and benefits that may have been appropriate for the deceased annuity owner may not benefit the inheriting annuity beneficiary in the same manner.
However, a recent private letter ruling appears to allow annuity beneficiaries to switch to a product that more closely aligns with their current needs. Please note that the IRS private letter rulings may not be relied on as precedent by other taxpayers or IRS personnel.
In a 2013 private letter ruling, the IRS expanded Section 1035 exchanges to include the exchange of one non-qualified annuity for another after the owner's death. A 1035 exchange allows the annuity beneficiary to move to a new product without creating an immediate taxable event. Prior to this ruling, annuity beneficiaries were locked in to the current product distribution options. Now there is an opportunity to make a 1035 exchange after the death of the annuity owner to a contract that may be more suitable to the beneficiary’s needs.
Adding new tools to your repertoire may be an option
As a financial advisor, it’s always important to be aware of new tools in the market that may help with your client’s needs. AXA Equitable has a product called Investment Edge, which includes an Income Edge feature that may provide a unique opportunity for beneficiaries of newly inherited non-qualified annuity contracts. Using the tool, beneficiaries can elect the Income Edge feature to set up a tax-efficient payment program, which allows the taxable portion of the inherited annuity to be spread out over the life expectancy of the annuity beneficiary.
Instead of distributions being withdrawn LIFO and creating a large tax implication during the beneficiary’s potentially high income years, Income Edge allows the taxable income to be spread over a larger time period. This flexibility can help the beneficiary have more control over how and when they will pay taxes.
By understanding the available options as a non-qualified annuity beneficiary, the individual can make sure that the annuity will fit their needs, now and in the future.
Important Note
As a reminder, this informational and educational article is not intended as, and does not constitute, investment advice. Your needs, goals, circumstances and tolerance for investment risk are unique, and you should work with your financial professional and consider these together before deciding whether the annuity product and its investment options and portfolios discussed are right for you.
For a prospectus, which contains more complete information including investment objectives, risks, charges, expenses, limitations and restrictions, please contact your financial professional. Please read the prospectus carefully before you invest or send any money.
Annuities, such as AXA Equitable’s Investment Edge, are long-term financial products designed for retirement purposes. Variable investment options within variable annuities are subject to fluctuation in value and market risk, including the possibility of loss of principal. In addition, annuity policies have limitations and a charge for withdrawals in the policy’s early years. The Income Edge feature available in the AXA Equitable Investment Edge non-qualified annuity contract is subject to conditions, limitations, and restrictions. Please see the prospectus for more information.
Please be advised that this article is not intended as legal or tax advice. Accordingly, any tax information provided is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor.