AN OPTION FOR INHERITED NONQUALIFIED ANNUITIES

NO STEP-UP FOR ANNUITIES

Typically, when someone passes away, many of the assets they own get a “step-up” in cost basis. This often minimizes the capital gains tax a beneficiary will have to pay upon the sale of the asset. For example, the investment value of a stock is adjusted to its market value at the time of death. If a stock XYZ was purchased at $10 a share (cost basis) and is worth $100 a share at the time of death, the cost basis receives a step-up to $100 a share. If it is sold for $100 a share, there will be no recognized capital gain (versus a $90 capital gain per share if sold before death).

Unlike investments such as stocks, however, nonqualified annuities do not get a step-up in cost basis at death. That means that the full amount of the gains (the current value of the account minus the value of the original investment) will be taxed as ordinary income to the beneficiary upon distribution.

Spouse beneficiaries of nonqualified annuities have the option of taking over the existing contract and naming a new beneficiary without taking any distributions from the contract, thereby deferring taxes even up to death if desired. For non-spouse beneficiaries, however, the value in inherited nonqualified annuities must be distributed within five years or over the beneficiary’s life expectancy using the stretch provision. Some beneficiaries choose to take income payments, while others will take the full amount of the annuity. In both cases, the beneficiary will have to pay income taxes on the money he or she receives. However, there is an option that provides the non-spouse beneficiary with a little more management of the contract.

1035 EXCHANGE

The tax code allows for a special transaction called a 1035 exchange, which, after an IRS ruling in 2013, in most cases permits beneficiaries of nonqualified annuities to exchange their existing contract for a new one without triggering taxes, as long as the exchange follows all the rules of inherited annuities.

The 1035 exchange can keep beneficiaries from being trapped in old products that aren’t suitable for their situation. Beneficiaries may be able to find and invest the annuity money in a new contract with terms (interest rates, payouts, allocations, etc.) that better suit them rather than the prior owner. The payout from the new contract may end up being larger than that which he or she would have received from the prior contract.

This does not change the cost basis of the contract—there is still no step-up—and income taxes will still be owed on any withdrawals, which must still be taken. The assets must be distributed on the RMD schedule already established at the time the beneficiary inherited the contract. The new contract, however, may provide a higher rate of return on the existing assets or better fit with the beneficiary’s financial situation. In this way, the beneficiary is able to exercise some control over the way the money is working for them.

To use a 1035 exchange, the original owner cannot have already annuitized the contract. Be mindful, as well, that an exchange made in the first few years of the contract’s life may trigger surrender charges.

INHERITED QUALIFIED ANNUITIES

Annuities opened with qualified funds—IRA or other retirement plan monies—can also be transferred to another contract or inherited IRA account as a rollover. The new contract or account will also be considered qualified, so a non-spouse beneficiary will still have to take distributions and pay taxes on them as directed by the IRS (unless the account is a Roth).

THERE ARE OTHER OPTIONS

Annuities are very complicated, both from an investment and a tax perspective. Before you purchase one (especially if you’re hearing about it during a complimentary dinner at Ruth’s Chris Steakhouse!), be sure to consult an annuity expert to review the nuances of the considered contract, your situation, and alternatives. It’s important to note that a 1035 exchange is not your only option, although it might be one to consider if you have inherited a nonqualified annuity. Depending on your needs, an alternative approach might be more appropriate. For an analysis of your situation, reach out to us at Day Hagan.

Best,

Natalie Brown, CFP®
Director of Client Services
Day Hagan Private Wealth

—Written 4.22.2021.

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