Is a Survivor Annuity Death Benefit Taxable?

Note: With the passage of SECURE Act 2.0 in 2022, provisions of the SECURE Act from 2019 have been updated. For the most part, inherited IRAs and their RMD rules remain the same except for inherited special needs trusts. Talk to your financial professional for guidance on your personal situation and for any other changes coming from SECURE Act 2.0 that may affect you financially.

You may have heard of annuities and how they are the only thing besides Social Security that can pay you guaranteed lifetime income. But what happens to an annuity when someone passes away? The tax rules surrounding survivor or inherited annuities are already complex, but the SECURE Act and now SECURE Act 2.0, federal laws passed in 2019 and 2022, have made them even more complicated.

The proceeds in a survivor annuity are generally taxable when the heirs receive them. If the recipient isn’t a spouse of the original annuity owner who passed, that recipient will pay taxes on the money they receive from the annuity.

If the surviving recipient is a spouse, then there are some steps that they can take to defer the taxes on the annuity proceeds. How much of the proceeds are taxable will depend on what type of account the annuity was housed in.

Most annuities are bought with pre-tax qualified money, meaning the premiums often come from a traditional IRA, a 401(k) plan, or another qualified plan. Since most annuities are bought with this pre-tax money, we will talk about how the SECURE Act can affect an heir’s tax burden now.

Inherited IRAs Before the SECURE Act

In the years before the SECURE Act was passed, many households bought annuities with their IRA money to create stretch IRAs. A stretch IRA was a tax planning strategy. It came into play when the original annuity owner dies.

If a non-spouse beneficiary inherited the IRA, the beneficiary could “stretch” out their tax liability on the inherited IRA money over their lifetime. The required withdrawals are calculated based on their remaining life expectancy.

Hence their overall tax burden could be reduced with this lifetime approach. It was a nice alternative to dealing with the tax bill over a few years after the IRA owner passed. The younger the heir is, the smaller their tax burden might have been each year.

However, the SECURE Act changed this. It did away with the stretch IRA and replaced it with a 10-year distribution rule for inherited IRAs. This, of course, begs the question of what happens to an annuity inside an inherited IRA now.

What Happens to an Inherited IRA Now?

According to Scott Ditman with Berdon Accountants & Advisors, now the entire IRA must be distributed within 10 years of the owner’s death. The beneficiary has some choices in terms of how long they stretch out those distributions. Ultimately, though, the account must be “emptied” by year 10.

You can withdraw all of the money from your IRA annuity in year one. But you could substantially increase your overall tax bill by doing so.

Exceptions to the New Rules

Some exceptions apply to this new 10-year rule, so check with your tax advisor and estate planning attorney to see if those might apply to you.

It’s also prudent to consult with experienced professionals in these areas if you are generally wanting to know the tax consequences of different options. That can help with making an efficient wealth transfer to your loved ones.

That being said, these exceptions are listed as follows:

• Surviving spouses are still exempt. They can roll the deceased account holder’s IRA into their own and defer taking distributions until the date when the decedent would have reached the age requiring him or her to take required minimum distributions.
• Chronically ill and disabled beneficiaries are exempt.
• Minors are exempt until they reach the age of majority.
• Beneficiaries who are less than 10 years younger than the decedent are exempt.
• Beneficiaries who have already inherited an IRA and are currently taking taxable distributions from their IRA(s) before January 1, 2020.

The exemption status is determined on the date of death of the account holder. The 10-year rule kicks in for minors once they reach the age of majority.

The five-year rule still applies to any IRA that has no designated beneficiary, or if the beneficiary is the decedent’s estate, a charity, or other non-individual. In these instances, the old rules still apply. Conferring with experienced professionals can help greatly in these situations, as they can become very complex.

What About Required Minimum Distributions?

Before going into more detail, let’s quickly review required minimum distributions. Before the SECURE Act was passed in 2019, you would have to start taking mandatory minimum withdrawals from your 401(k), traditional IRA, or other tax-advantaged retirement account once you turned 70.5.

These mandatory withdrawals are called “required minimum distributions,” or RMDs for short. The penalty for missing them is quite extensive, with a 25% excise tax by the IRS.

However, the SECURE Act and subsequently the SECURE Act 2.0 raised the starting age for RMDs to later ages, which depend on your date of birth. For those born on July 1, 1949, through and including December 31, 1950, the starting age for RMDs is 72. For those born on January 1, 1951, through and including December 31, 1959, it’s 73. This age-point is slated to rise to 75 in 2033, unless the law changes again.

The penalty for missed RMDs still applies, but now account holders can wait a little longer until they have to start drawing on their retirement money.

RMDs and The Five-Year Rule

Now, let’s go back to our original discussion. Say that an account holder who passed hadn’t reached the age when they would be required to start taking mandatory minimum distributions.

In that case, the balance of the account would have to be depleted by the end of the fifth year after the year of that person’s death.

If the account holder was taking required minimum distributions before they died, then distributions can be taken over the single life expectancy of the deceased owner, as listed in the IRS mortality tables.

What About Distributions from Roth IRA and Non-Qualified Annuities?

Roth IRAs must still be emptied out by the beneficiary within that 10-year period. However, the withdrawals made by the beneficiary are tax-free, according to Ditman.

As for non-qualified annuities, you have already paid income taxes on the original premium money. The annuity allows the money to grow tax-deferred and could, in theory, allow this tax-advantaged growth to happen until the annuity owner’s death.

After that, the beneficiary would probably have a tax bill. They would pay income taxes on the amount of growth that is in excess of their cost basis, just as the decedent would have to if they were still alive.

Planning Ahead Pays Off

If you were looking to spread out the distributions from an IRA that you will eventually inherit over your lifetime, that option has changed. Consult with a financial professional to explore what the ramifications will be for you now that the payments can be spread out over ten years.

This may put you into a higher tax bracket. It depends on the account value of the IRA, your age when you inherit the account, and other factors. Your financial professional can help you to find ways to manage your tax bill and make the best possible use of the money you receive.

Proactive planning can go a long way toward making the most of your money for generations to come. Consult your advisor today for more information on the rules for survivor annuity death benefit proceeds, inherited IRA distribution rules, and other ways in which the SECURE Act might affect you.

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