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An annuity is an investment product that pays a person a steady stream of income in return for a lump-sum payment. Most people who invest in annuities are doing it for retirement income, but sometimes, they also are taking care of their loved ones.
An annuity may be left to a surviving spouse or other family member. Or, money remaining in an annuity account may be transferred to a beneficiary in the will of a deceased person.
There are a couple of options for handling an annuity if you receive one as a beneficiary.
Key Takeaways
- An annuity may be structured to pay a stream of income for the lifetime of the longer-living spouse.
- The payments will then simply transfer to the surviving spouse.
- In some cases, an annuity may pay a set amount of money that can be passed on to a designated heir if money remains in the account when the accountholder dies.
- The person who inherits can accept the money as a lump sum or in a series of payments.
Options for the Surviving Spouse
Annuities can have many variables, and one common option is a payment that continues for the lifetime of a surviving spouse.
If you are the surviving spouse, you can treat the annuity as your own income going forward. The payments will continue according to the particulars that your spouse arranged with the contract.
A surviving spouse, or any other person who inherits an annuity, has several other options for how the money is paid out.
Options for People Who Are Not the Surviving Spouse
If you inherit an annuity but are not the surviving spouse, you have three options:
- Take a lump-sum payout
- Take the full amount in installments paid over the next five years
- Receive the annuity in regular installments over your lifetime
You have 60 days to decide which option you prefer.
If the annuity payments have already begun, you must take the payments at least at the same rate as the original owner was receiving them. The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase.
When a person inherits an annuity, the gains stay with the policy.
Depending on the type of annuity, the tax will be owed on the lump sum received or on the regular fixed payments. The payments received from an annuity are treated as ordinary income, which could be from 0% to 37% marginal tax rate for 2024 and 2025, depending on your tax bracket.
If the annuity was purchased with after-tax dollars, ordinary income is owed on all gains but not on the earned principal. A portion of each annuity payment will be considered a tax-free return of principal, spreading the tax liability out over time, unless you select the lump-sum payout.
Lump-Sum Distributions
A lump-sum distribution is a one-time payout rather than a series of payments over time. Lump-sum payments can have tax implications.
The Internal Revenue Service provides guides to help understand the tax implications of lump-sum payouts. According to the IRS:
A lump-sum distribution may be paid under several circumstances:
- The plan participant’s death
- After the participant reaches age 59½
- The participant, if an employee, separates from service
- After the participant, if a self-employed individual, becomes totally and permanently disabled
Tax obligations may be deferred by rolling the lump-sum distribution over into an individual retirement account. According to the IRS: “You should receive a Form 1099-R from the payer of the lump-sum distribution showing your taxable distribution and the amount eligible for capital gain treatment. If your Form 1099-R isn’t made available to you by January 31 of the year following the year of the distribution, you should contact the payer of your lump-sum distribution.”
Annuities often have high fees, so it pays to shop around and consider other types of investments.
What Happens to My Annuity When I Die?
It depends on the contractual terms of your annuity:
- If your spouse is a joint owner of the annuity and you die first, your spouse will continue to receive the annuity.
- If your spouse is the named beneficiary of your annuity and you die first, your spouse will receive the death benefit.
- If your annuity is for a set term and you die before the payments run out, your surviving spouse or any other beneficiary you name will receive the remaining money.
How Can I Protect My Annuity in a Divorce?
Some nonqualified annuities might be able to get divided up in a divorce. However, please contact a tax and divorce expert to establish the proper documentation to protect your annuity.
Do I Have to Pay Taxes on My Annuity?
With rare exceptions, annuity payments are taxable as ordinary income. You’ll owe income taxes of between 0% and 37%, depending on your tax bracket. Tax is generally withheld from the payments.
The Bottom Line
For a couple, an annuity is often a means of providing a regular source of income for the life of both people. Depending on the type of annuity, the surviving spouse may continue to receive the income or may receive a death benefit.
An annuity contract may also specify a set number of payments. If you die before the payments are exhausted, your beneficiary will receive the remaining money.