12 Jan When do I have to take money from this inherited annuity?

Q. My father had a non-qualified annuity and he passed in June 2017. I inherited the annuity. It’s my understanding that I must remove the funds within five years from his death. Is that correct?
— Beneficiary

A. We’re sorry to hear about your father’s passing.

Before turning to your specific questions, let’s briefly review what an annuity is and what it means for an annuity to be nonqualified.

Annuities come in dozens of varieties, but at bottom an annuity is a type of contract with an insurance company that provides you with a series of regular payments over time, either for life or for a fixed period, in return for an initial investment, said Gene McGovern, a certified financial planner with McGovern Financial Advisors in Westfield.

Annuities can be immediate or deferred. An immediate annuity usually begins payments within one year after the initial purchase, he said.

Deferred annuities begin payments at a future date beyond one year and have significant tax advantages, he said. Just as with an IRA or other retirement account, any gains on the money invested in a deferred annuity are tax deferred until the money is withdrawn.

An annuity is “qualified” if it is held inside an IRA or similar retirement account, McGovern said. An annuity that is not held inside a qualified retirement account is called a “nonqualified” annuity, he said.

“The owner of an annuity contract can designate a beneficiary, such as you. Income taxes on any gain in the deferred annuity over the amounts contributed by the original owner must be paid by the beneficiary when the funds are withdrawn,” he said. “The price of all that tax deferral is that any gains in the annuity are taxed at ordinary income tax rates rather than at the lower rates that generally apply to capital gains.”

As the non-spouse beneficiary of your father’s nonqualified annuity, you generally would have had three options for withdrawing the money at the time of his death: the five-year rule, annuitization, or the so-called nonqualified stretch, or life expectancy method, McGovern said.

A spouse has the additional option of continuing the existing deferred annuity as his or her own.

“The annuitization and the nonqualified stretch options both allow the beneficiary to stretch out the distributions from the annuity over his or her lifetime, either by receiving annuity payments for life or by taking required minimum distributions over the beneficiary’s remaining life expectancy,” he said. “However, both of those `stretch’ options must begin distributions no later than one year after the death of the original annuity owner.”

Since your father died more than three years ago, in June 2017, the only option now available to you would be the five-year rule, McGovern said.

Under that rule, the entire amount must be withdrawn from the annuity no later than five years after the date of your father’s death, he said. That would mean withdrawing all the funds no later than June 2022.

“You can withdraw some or all of the funds at any time during the five-year period, or wait until the end, so long as the entire account is emptied at the end of five years,” he said. “That allows you some flexibility for tax planning.”

McGovern said under the five-year rule, all gains in the annuity come out first and are taxed when you withdraw the money — before any nontaxable contributions are received back. The gains are determined at the time of withdrawal, not at the time of your father’s death, he said.

To minimize income taxes, then, you could try to time the receipt of those gains.

For example, let’s assume that the annuity account is currently worth $100,000 and that it contains $25,000 of your father’s original contributions. The difference between those amounts, $75,000, is taxable gain. As a result, the first $75,000 that you withdraw is all taxable at your highest marginal income tax rate. The last $25,000 to be withdrawn will be tax free, McGovern said.

If your income in 2021 versus 2022 would change significantly, you could time the distribution to minimize your taxes, he said.

“To take one example, if you are temporarily out of work in 2021 but start a new job later in the year, taking out more of the gain in 2021 would result in lower taxes because your income and tax bracket would be lower,” he said. “On the other hand, if you plan to retire toward the end of 2021 or in 2022, you may be better off taking most of the money out in 2022, assuming your income is lower in retirement.”

Finally, if your income between the two years won’t change very much, you may want to spread out the taxable gains by withdrawing about half of the gain this year and the other half next year, he said.

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This story was originally published on Jan. 12, 2021.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.