If you are a non-spousal beneficiary on an annuity contract, there is a lesser known tax strategy that can significantly reduce the income tax you may pay if there is a built up gain in the policy. Distributions from a non-qualified annuity contract are taxed “gain first” as ordinary income called income in respect to a decedent. When the owner of a non-qualified deferred annuity dies and leaves the money to a non-spouse individual beneficiary, that beneficiary has several different distribution options: 1) The Five-year Rule 2) Nonqualified Stretch or 3) Annuitization
The five-year rule requires that the entire balance of the annuity be distributed within five years of the owner’s death. The beneficiary may:
- Take all the proceeds soon after the death of the owner
- Take discretionary amounts out at any time during the five-year period
- Wait until the fifth year to take out all the annuity proceeds
Regardless of how the beneficiary chooses to apply the five-year rule, their annuity income will be taxed to the extent of gains distributed from the contract, and gains are distributed first.
If a trust, charity or estate is the beneficiary of a nonqualified deferred annuity, the five-year rule is the only distribution option available.
Nonqualified Stretch, a.k.a. The Life Expectancy Method or One-year Rule
This is similar to the stretch or extended IRA concept, where the beneficiary uses his or her remaining life expectancy to calculate an annual required minimum distribution. This can be characterized as a systematic withdrawal over life expectancy. A combination of factors may make this option advantageous:
- Continued tax-deferred growth over the beneficiary’s lifetime
- Smaller income tax bills by taking only the required minimum distributions
Compared to other distribution options like the five-year rule or annuitization, these factors may create more money over time for the beneficiary. Some important points to consider are:
- The first required minimum distribution from a nonqualified annuity must be taken within one year of the date of the annuity owner’s death
- In each subsequent year, the beneficiary must take at least a life expectancy-based required minimum distribution by December 31
- The beneficiary’s initial life expectancy factor is determined using the IRS Single Life Table and then one (1) is subtracted from that life expectancy factor for each subsequent year—35, then 34, then 33 and so on
- The beneficiary is not limited to taking only the required minimum amount; he or she may take more, up to the entire cash value
- The beneficiary, as the owner of this now-beneficial nonqualified annuity, determines the investment options, so he or she bears the investment risk with this option and determines the date of the yearly required distributions
- The beneficiary is the taxpayer on the gains of the annuity, and the gains are taxed first
- Multiple beneficiaries may each use their own remaining life expectancy to calculate the required distributions (if separate beneficial annuities are created for each beneficiary)
This strategy may be optimal for the right situations but it is advisable to obtain advice from a qualified tax expert before making a decision on your distribution election.
Raymond James and its advisors do not offer tax advice. You should discuss any tax matters with the appropriate professional. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Thomas Fleishel and not necessarily those of Raymond James.