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Inherited annuities can be a tax time bomb.

Lured by the promise of tax-deferred interest and returns backed by insurance companies, many savers over the last decade have invested large sums of non retirement funds in deferred annuities. In this rush to avoid taxes they may be passing a tax time bomb to their heirs.

The ultimate goal of good estate planning is to ensure that wealth gets transferred to the right people, at the right time, with a minimum of cost involved. This implies that merely shifting the tax burden from the current generation to future heirs is not an acceptable transfer alternative. Yet, this is exactly what happens in the case of deferred annuity ownership when the owner dies before the annuity is annuitized.

Deferred annuities are primarily purchased for two reasons. First, by leaving the money alone inside the annuity contract, tax-deferred growth of principal occurs. Taxes are not paid on this growth until the owner of the contract withdraws the money.

These annuities can also be used to produce an income stream if the owner elects to annuitize. The amount paid is an obligation of the insurance company backing the annuity and may or may not be guaranteed, depending upon the type of annuity.

This annuitization process involves an irrevocable decision to accept a payment for the annuitant's life or a term of years, usually no fewer than five. The money paid to the owner is comprised of tax-free return of principal plus some interest.

For those owners who never intend to annuitize, but instead are using annuities to minimize current taxable income with plans to eventually pass this wealth to the next generation, a tax trap awaits. At the owner's death, if the contract is passed to a non-spouse beneficiary, the beneficiary must pay income taxes on the deferred income at the beneficiary's ordinary income tax rate.

For spousal beneficiaries, the transfer of ownership due to the death of the spouse does not trigger a taxable event. However, if a non-spousal beneficiary inherits a deferred annuity, that beneficiary has several distribution options.

A five-year rule allows the beneficiary to withdraw portions or all of the annuity values over a maximum of five years.

The beneficiary may also elect a nonqualified stretch option that allows at least annual withdrawals based upon the life expectancy of the beneficiary. This is similar to IRA Required Minimum Distribution Rules, in that a minimum amount must be distributed, but the new beneficiary owner may elect to withdraw additional amounts. With both of these options, withdrawals are taxed as ordinary income to the extent of the gains in the contract.

The beneficiary may elect to annuitize the inherited contract selecting any available single-life payout option or a term-certain-only option that is shorter than life expectancy may be used. Annuitization transfers the investment risk from the beneficiary to the insurance company in exchange for the guaranteed income stream. Also, because this is annuitization, the beneficiary has the benefit of the exclusion ratio treatment on distributions, with each payment being partially a tax-free return of principal and taxable interest.

Recently, the IRS has also issued a Private Letter Ruling allowing the beneficiary of an inherited deferred annuity to do an IRS Section 135 tax free exchange from an older, inherited annuity to a more contemporary contract offering better terms than the older contract.

By allowing this exchange, the IRS permitted the beneficiary to exchange the entire pre-tax value of the inherited annuity, rather than requiring that she take a lump sum distribution of the inherited annuity interest, pay taxes on this distribution and then purchase the replacement annuity contract with the after-tax value.

Wendell Cayton is an independent Registered Investment Advisor Representative of Wealth Management Advisors LLC, a registered investment advisor firm registered in Washington and California. His views are his alone and not those of any company with whom he may be associated. Cayton does not give legal or tax advice. Those seeking such advice should consult appropriate professionals. He can be contacted at His website is
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Title Annotation:TAKING STOCK
Author:Cayton, Wendell
Publication:Wenatchee Business Journal
Date:Oct 1, 2015
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