Sales & Marketing | 11.11.26

Before You Cash That Check, Consider An Inherited Annuity

by: Allison Anne Hoyt

When a beneficiary of a non-qualified annuity contract calls their financial advisor after the owner's death, the conversation often begins with a simple question: "What do I do now?"

Unfortunately, many non-spouse beneficiaries are led to believe their choices are limited to a lump-sum distribution or a five-year payout period. Sometimes that assumption comes from independent research. Other times, it comes from the insurance carrier itself. While certain carriers may contractually restrict the post-death options they offer, advisors should not assume those are the only solutions available. In many cases, additional planning opportunities exist that can preserve tax deferral, improve flexibility and place the beneficiary in greater control of the inherited asset.

Nuts and Bolts: Inherited Annuity Contracts

The inherited annuity contract is a lesser-known, but powerful option for non-spouse beneficiaries. An inherited annuity is a new annuity contract issued by an insurance carrier to a non-spouse beneficiary after the owner of the original contract has passed away. Two important features distinguish it from the original contract:

1. Minimum distributions must be taken annually, and
2. There is no 10% tax penalty for distributions made to beneficiaries under age 59 ½.

Because it is considered a brand-new annuity contract, an inherited annuity may be subject to early withdrawal charges and/or market value adjustments for the first few contract years. These features serve to disincentivize large withdrawals from the contract during that time. However, the free-withdrawal allowance provides a meaningful way to access capital in the early years of the contract without penalty — for example, if the initial inherited annuity account value is $100,000, up to $10,000 (10%¹ ) may be accessed in a single year with no penalty. And after a certain number of years — typically three, five or seven depending on the contract – penalty-free withdrawals in any amount may be taken.

If a non-spouse beneficiary is in need of a lump sum payment beyond what would be available under the inherited annuity’s free-withdrawal allowance, it’s also possible to take a portion of the original contract in cash and do a partial exchange of the remaining account value into an inherited annuity. Let’s take a look at some of these rules in action.

Case Study: Claire (41) Inherits a Fixed-Indexed Annuity (FIA) Contract²

Claire, age 41, is the sole primary beneficiary of an FIA owned by her mother, who recently passed away. The account value of the FIA is $500,000 (the contract had roughly $200,000 of gain). Claire asks her financial advisor what her options are.

Her financial advisor learns that the current insurance carrier is limiting Claire’s options to a lump sum distribution or a five-year payout. Claire and her husband are high earners (24% federal bracket), and that amount of forced income in a short period of time would have undesirable tax consequences, pushing them into a higher tax bracket (32% or 35%). They also like the idea of continuing the tax deferral on the assets within the FIA beyond five years, as the majority of their other assets are currently taxable.  

Potential income tax: Lump sum distribution

 

Potential income tax: 5-year distribution³

Claire’s financial advisor knows of a solution that could minimize the tax consequences of inheriting her mother’s FIA, extend the tax deferral of the investments within the FIA and give Claire significant control of when and how much to withdraw: an inherited annuity contract.

After speaking with Claire, her financial advisor initiates an exchange from the FIA contract at the current carrier to an inherited FIA contract at a different carrier (Claire is risk-averse like her mother was!) The exchange itself is not taxable. Claire will be required to withdraw a small but increasing percentage of the FIA account value each year the FIA remains in force — but can take out more if she wants to. This payment requirement is often referred to as the “non-qualified stretch.” Claire will be able to stretch payments from the FIA over her life expectancy — which for a 41-year-old is around 44 years!⁴ Claire’s financial advisor explains that, if possible, she should take out no more than 10% of the account value during the first seven years to avoid any early withdrawal charges. Thereafter, any amount can be withdrawn without penalty. 

Claire’s Non-Qualified Stretch: The First 10 Years⁵

Claire’s financial advisor explains that her required distributions are the minimum amount that must be taken out each year. During the first seven years, up to 10% of the account value can be taken without incurring any early withdrawal charges. Gains in the contract will come out first, and it’s likely that distributions will be fully taxable for several years; after the gain is recovered, remaining distributions will be non-taxable. Claire’s financial advisor also explains that these figures are not guaranteed, but because an FIA is an insurance product, she is contractually guaranteed to get annual payments of at least $11,416 for 43 years and fully recover the $500,000 account value.⁶ However, if market performance is positive during any of those years, it’s likely she will receive greater annual payments and recover more than the initial $500,000 account value. In fact, the non-guaranteed illustration estimates that Claire could recover almost $3,000,000 over this period!

Claire is ecstatic that she will not have to take a lump sum distribution or liquidate the account within five years of her mother’s passing. The inherited annuity contract with non-qualified stretch will allow her to safeguard the inheritance from her mother and put Claire in the driver’s seat — Claire will be able to change the indexed strategies (with her financial advisor’s input), name her own beneficiary and take money from the contract when she needs it. She is considering taking her family on an amazing trip in 10 years when her daughter graduates from high school — and funding it with the legacy her mother left her and that she nurtured and grew with the help from her financial advisor.

The Financial Advisor’s Opportunity

Claire's experience illustrates a reality that many advisors encounter when non-spouse beneficiaries inherit annuity contracts. Too often, the options initially presented by the insurance carrier are taken as the only solutions. When advisors understand the flexibility that may exist through post-death planning opportunities, they are often able to present alternative options that are more closely aligned with the beneficiary's needs and goals.

For financial advisors willing to look beyond the payout options presented by the original carrier, inherited annuity contracts can offer non-spouse beneficiaries greater flexibility, continued tax deferral and all-around more desirable outcomes. In an environment where clients increasingly value personalization and tax efficiency, understanding the potential role of inherited annuity contracts can help advisors deliver a higher level of service at a time when beneficiaries are often making important financial decisions under emotional circumstances. The next time a client asks, "What do I do now?" the answer may involve far more possibilities than simply cashing the check.

A Closer Look at Terms

• Fixed-indexed annuity contract (FIA): An FIA may be an appealing option for conservative investors who do not want to lose principal; they trade principal protection for limited upside potential in the form of caps and allocate funds to various strategies that track the performance of well-known indices such as the S&P 500. A cap is a limit on how much growth of an index will be credited to the FIA account value.
• Post-death 1035 exchange: It is possible to exchange one annuity contract for another annuity contract that is more desirable. The annuity contract may be at the same or a different insurance company. This process is typically accomplished completely income-tax free thanks to Internal Revenue Code section 1035. The holder of an annuity contract may complete one or more exchanges during their life, or the beneficiary of an annuity contract may complete one or more exchanges after the holder’s death (i.e., post-death 1035 exchange).