If you inherit a tax-deferred annuity from your spouse, you have all the same withdrawal options that your spouse would have had. You can keep the annuity, switch to another one (in a tax-free exchange), or take the money out on whatever schedule the contract permits. Ordinary income taxes are due on the earnings when the money is withdrawn.
If you inherit an annuity and are not the spouse—say, you received it from your mother or a domestic partner—you have three options:
- Take all the money, over no more than five years from the time you inherited. You’re taxed when you take the money out. The first payments are treated entirely as taxable earnings. Once you’ve taken all the earnings, the final payments are a tax-free return of the capital originally invested in the contract.
- Take systematic withdrawals based on your life expectancy, if your contract allows it. Each year, you take out the amount that’s appropriate for your age or a larger amount if you need the money. This option stretches out your payments and gives you flexibility, although there’s no guarantee that the money will last for life. As with the five-year payout, the first payments are treated as taxable earnings, with the final payments a tax-free return of capital.
- Buy an immediate-pay annuity (either fixed or variable). This choice gives you an income for life, no matter how long you live. It’s also the most tax efficient. Part of each payment is taxable income, and part is a tax- free return of capital.
Laura Bushnell is Editor in Chief for National Review Brand Foundation of Consumer Updates and based in Boston. Previously, she held senior VP level positions in corporate finance and consumer financial planning firms.