Ask an Advisor: What Should I Do With the Annuity I’m Inheriting? Take a Lump Sum, Roll it Over or Defer Payments?

Ask an Advisor: What Should I Do With the Annuity I’m Inheriting? Take a Lump Sum, Roll it Over or Defer Payments?

Financial advisor and columnist Brandon Renfro

I recently learned that I am the beneficiary of an annuity in the amount of $54,845 from a friend. I was given choices on how to receive the money: lump sum, roll it over or defer the payments over a certain number of years. I don’t have anything saved for retirement and I don’t know what to do. What’s the best option and how do I not get stuck paying a lot of taxes?

– Shannon

Sorry to hear about your friend’s passing, Shannon. As with any question and answer set in a context like this, I won’t be able to tell you specifically what you should do. But what I can do is help you frame your situation so you can better understand what’s going on and what your options are. Hopefully, this will help you decide what’s best for you. (And if you have a specific financial planning question like this one, consider speaking directly with a financial advisor.)

Inheriting an Annuity

The two big variables that determine the tax treatment of an inherited annuity are whether or not you are the spouse of the annuitant and whether the annuity was qualified or non-qualified.

Based on your question I believe that you are a non-spouse beneficiary of a qualified annuity. This means the annuity is held within some type of retirement account like a 401(k) or IRA. If my assumption is correct then you’ll owe income tax at your personal tax rate when money is distributed from the account. It’s important to understand that because it affects which option you should choose. (And if you want insight into how your decision about an inherited annuity will affect your overall financial or retirement plan, consider working with a financial advisor).

Options for Handling Your Inherited Annuity

Young man mulls his options for handling an inherited annuity

Young man mulls his options for handling an inherited annuity

If you have in fact inherited a qualified annuity, whether you choose to receive payments, take the full amount as a lump sum distribution or roll it into an inherited IRA will have specific tax implications. You need to keep in mind that the money is taxable when you withdraw it. If you elect to receive payments, then each payment is included in your taxable income as you receive it.

  • If you take the full amount as a lump sum, understand that you’ll have to include that full balance in your taxable income in the year the distribution occurs.

  • If you roll it into an inherited IRA, the distribution rules for inherited IRAs will apply. You’ll likely need to withdraw the full balance within 10 years. Rather than the full amount becoming immediately taxable, each distribution is taxable in the year you receive it.

Generally, from a tax perspective, it is better to spread the distributions out over time rather than take a lump sum. However, that isn’t always the best route. It depends on the tax bracket you are in now and what your projected tax brackets may be in the future. The idea is to take your distributions when they will be subject to the lowest possible tax rate. (And if you would like more advice on your tax strategy, consider talking with a financial advisor.)

Consider Your Goals

Woman considers how to take an inherited annuity

Woman considers how to take an inherited annuity

While tax minimization should certainly factor into your decision, it also may not be the most important factor. Consider your own situation and goals when you decide what to do, and choose the option that most effectively utilizes your inheritance. That may be a combination of tax efficiency and something else like cash flow management.

For example, you may have debt you need to get rid of or be in dire need of home repairs. If using the annuity in a way that allows you to accomplish one of those helps you move forward or get out from under a financial burden then it is worth considering.

Next Steps

Assuming you have a qualified annuity then you’ll owe taxes when you withdraw money. Depending on your total situation and other goals you may want to spread your distribution out over a number of years or take a lump sum. There’s not a single best answer that applies to everyone.

Tips for Finding a Financial Advisor

  • Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • Consider a few advisors before settling on one. It’s important to make sure you find someone you trust to manage your money. As you consider your options, these are the questions you should ask an advisor to ensure you make the right choice.

Brandon Renfro, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email [email protected] and your question may be answered in a future column.

Please note that Brandon is not a participant in the SmartAdvisor Match platform, and he has been compensated for this article.

Photo credit: ©iStock.com/PeopleImages, ©iStock.com/Vadym Pastukh

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