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Dr. Fiona Chen
Dr. Fiona Chen, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 300
Experience:  Former IRS Revenue Agent
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How do annuity work when you are beneficiary? What is the

Customer Question

how do annuity work when you are beneficiary?
JA: The Accountant will know how to help. Please tell me more, so we can help you best.
Customer: What is the IRS tax rule?
JA: Is there anything else the Accountant should be aware of?
Customer: My husband died and he had an annuity. Not sure what I should do.
Submitted: 1 month ago.
Category: Tax
Customer: replied 1 month ago.
The letter says it is fixed Annuity Non-Qualified.
Choices are -
Lump sum
deferral of proceeds
spousal continuation
annuity income option
What are the tax issues?
Expert:  Dr. Fiona Chen replied 1 month ago.

Dear Customer,

I am sorry for your loss of your husband.

1) There are many types of annuities. They are sold and held by insurance companies.

2) As a beneficiary, once you notify the insurance company of your husband passing, they will send you package to explain to you your options.

3) Always try to locate the contract signed and issued when your husband took out the policy. It looks like a little book or magazine. That contract is very important. If you cannot find it, ask the insurance company send you another copy.

4) Consult with your tax professional to go over both your contract and choices offered currently. You can consult with your financial advisor, as well. However, your financial advisor may have a motive to get you move the annuity to his/her investment and control. Be aware.

5) Below are several items suggested for your consideration,

a) Examine and go over to see whether there is any type of life insurance provision and how this provision will affect the choices you are facing.

b) If the policy has not been taken out any distribution and you can somehow keep it the same way, that is, to delay its distribution and to defer the tax liability, do that. Don't take anything out.

c) Usually, if the policy is purchased with after-tax money, it does not have a required minimum distribution requirement as an IRA annuity account.

d) Facing any IRA account, remember to say and select the option of "I want to have it roll over and treat it as my own IRA". Never use the word of "inherited" in your choice. They may misunderstand that you want to take it as an inherited IRA. You are spouse. So, you are the only person with a choice of not treating it as an inherited IRA. The inherited IRA has less life time length to take out the distribution.

e) I just saw your second posting. So, we will continue with the major point first before we return with the suggestions.

6) Below is a citation helping us to understand the term of "Non-qualified."

Pre-tax or After-tax?

The term “non-qualified” hints that there is another type of annuity, called “qualified.” So what are the differences? There are a few, as well as some similarities.

Qualified is just IRS language for funding with pre-tax dollars, meaning the contribution itself could qualify for a tax deduction, lowering taxable income. When you take a distribution from a qualified annuity, the entire distribution amount (contributions and earnings) is subject to ordinary income taxes.

A non-qualified annuity is funded with after-tax dollars, meaning you have already paid taxes on the money before it goes into the annuity. When you take money out, only the earnings are taxable as ordinary income.

7) Therefore, what you have is a after-tax annuity which means you don't have to take the money out unless you need money.

8) Do not take out a lump sum for the apparent reason. This option will make your tax the highest.

9) Just by looking at the title of the choices, it is hard to comprehend what they really mean. You have to talk with the Insurance representative to make sure you fully understand what each choice is. Take notes. Repeatedly asking the question. Go to their website to study these options. These terms are a sort of used by this particular insurance company and have no universal definition. Sometimes, my clients even ask me to sit with them when they call the insurance company to make sure that we are all on the same page for the terms of the annuity.

10) Let's assume that we are looking at the tax consequence only and try to avoid income tax and try to reduce the distribution.

10.a) However, whatever you chose, please make sure the life insurance feature in the policy, if any, is handled properly. That factor, even non-taxable, may affect your decision on what to do with the remaining choice.

11) If your husband used to take out the annuity and you both live comfortably with the distribution, you may continue with that option. However, starting next year, you will be reporting on the tax return as single. So, you want to reduce income as much as possible, too.

12) It seems that "deferral of proceeds" sounds attractive. Make sure ask the insurance representative the following:

a) If you chose this option, does it mean that you don't have to take out the money at all? How long can you do this? If you chose this option, what is the rate of return? What if later on, you decide to take out the money, will this chose affect or restrict your future choice to take out the money?

p.s. Look at how even professionals like us, will have these many question on the choices. Just be persistent and make sure you understand the answer so that you have all the factors for your decision to make.

13) I am not sure about the "spousal continuation". Does this mean that your husband already taken out the annuity, and how this is different from the choice of "annuity income option".

14) For all the choices, write down and keep a number of the total payment as a result. For example, if you start to take the annuity, how much is the payment and for how long. Then, you can compare with so called spousal continuation and see how much the payment is, and for how long.

15) There is a possibility for you to reinvest the annuity to purchase another policy without taking any money out at all and defer the tax. Ask them whether it is possible. Or you may consider this option for the future. The reason for a potential benefit of such a alternative is that usually if the money is kept in the same policy, the rate of return probably is very small and a little higher than the current interest rate. If you roll over and purchase another policy, you can have the first few years still much higher rate of returns. Unless you have enough other assets to live on and to use, don't consider this option because any new policy will have principle penalty if you have to take the money out.

It is very valuable that you have a mature policy and is free to use without the policy to penalize you from taking out the money.

16) It looks like that the deferral of proceeds has the least tax effect, lump sum has the largest tax effect. But you need to ask those questions on the "deferral of proceeds". The other two we are not sure here because we don't have the exact definition of the terms. You need to consider tax effect and also the total payout in terms of your investment return.

17) Do not sign the paper until you are a sort of 100% sure what your choice is.

Please feel free to follow up.


Fiona Chen, MPA, Ph.D., CPA, ABV, CFF, CITP

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