You’ve inherited an annuity—now what?

Annuities are one of the many tools investors have for building wealth and securing their financial well-being. An inherited annuity can do the same for you as a beneficiary.

Annuities are contracts between the insurance companies that issue them and the people who buy them. Although there are different types of annuities, each with its own benefits and features, the key aspect of an annuity is that it pays either a series of payments or a lump sum according to the contract terms. Because the payout is a contractual obligation, people commonly use annuities to make sure they can generate enough secure income for retirement.

If you recently inherited an annuity, you may not know where to start. That's completely understandable—here's what you should know.

In addition to the insurance company, several parties are involved in an annuity contract.

• Annuity owner: The person who enters into and pays for the annuity contract is the owner. The owner selects contract provisions (such as a death benefit) to be included and names the beneficiaries. The owner has complete control over the contract and can change beneficiaries or terminate the contract subject to any applicable surrender charges. An annuity may have co-owners, which is often the case with spouses.

• Annuitant: The annuitant is the person whose life is used to determine the payout. The owner and annuitant may be the same person, such as when someone purchases an annuity (as the owner) to provide them with a payment stream for their (the annuitant's) life. However, this isn't a requirement, and the owner can name someone else as the annuitant or name multiple annuitants. Annuities with multiple annuitants are called joint-life annuities. As with multiple owners, joint-life annuities are a common structure with couples because the annuity continues to pay the surviving spouse after the first spouse passes. This can provide income security in retirement.

• Beneficiaries: Annuity beneficiaries are the parties designated to receive any applicable death benefits. People, trusts, organizations and charities can all be named as beneficiaries.

It's possible you may receive a death benefit as a beneficiary. However, that's not always the case. When a death benefit is triggered, payments may depend in part on whether the owner had already begun to receive annuity payments.

An inherited annuity death benefit works differently if the annuitant wasn't already receiving annuity payments at the time of their passing. In that case, if the contract provisions include a death benefit, it can be paid either as a lump sum or as a series of payments.

When the benefit is paid out to you as a lump sum, you receive the entire amount in a single payout. If you elect to receive a payment stream, you will have several options available, depending on the contract.

If the owner was already receiving annuity payments at the time of death, then the annuity contract may simply terminate. That's because annuity contracts are often written to provide annuity payments for the life of the annuitant. There are some notable exceptions, though.

If the deceased owner had elected an annuity payment stream that lasted for life with a guaranteed number of years, a death benefit would be available if the owner died with some of the guaranteed period remaining. Hypothetically, if the owner elected a life income with 20 years guaranteed and died in the 10th year, there would be a death benefit for the beneficiary. In this case, a beneficiary could continue receiving the annuity payments for the remaining 10 years or may prefer a lump sum. The lump sum is calculated to be the present value of payouts, which means it would be less than if the beneficiary continued the remaining payments.

As an alternative, let’s say the owner selected a joint income, covering the owner’s and a spouse’s lives. The owner could select a feature that would continue payments of 100% to the surviving spouse or select a different percentage, such as 50% or 75% of the original payment.

Payouts of inherited annuities must follow certain distribution rules; most beneficiaries that choose not to immediately withdraw the death benefit in a lump sum will either need to follow a five-year rule or a life expectancy payout rule for a nonqualified annuity.

As an exception to the five-year rule, the IRS also allows you to stretch the payments out over a period not exceeding your life expectancy. This option may not be available in all contracts, however, and it isn't available when the beneficiary isn't a living person, such as a trust or charity.

For a qualified annuity, such as an IRA, most beneficiaries must deplete the account within 10 years of the owner’s death. Spouses and certain other beneficiaries have additional options.

If you're a surviving spousal beneficiary, you have a few options for moving forward. For instance, you can transfer the contract into your name. If you choose this option, you can continue with the original terms of the annuity contract as though the annuity were your own. This can be a valuable strategy if the annuity is intended to provide you with income as an important part of your retirement plan.

If you want the annuity death benefits to go to your children upon your death, you can name them as beneficiaries or name a trust to provide for their care. The choice depends on their age, needs and level of responsibility. Annuity death benefits can also be a great way to leave a charitable legacy and provide financial help to a cause you care about.

These can be complex decisions to make, so it's wise to consult with a financial advisor or estate attorney before taking action.

Inherited annuities are taxable to you as the beneficiary. The exact tax implications vary depending on the type of annuity, your tax status and the chosen payout.

To understand the tax consequences of inherited annuities, it's important to first understand the difference between qualified and nonqualified annuities. The difference between these two types of annuities isn't due to contract terms or structure but how they're purchased:

• Qualified. Qualified annuities are purchased with pretax dollars inside of retirement accounts like IRAs.

• Nonqualified. Nonqualified annuities are purchased with after-tax money.

Annuities are tax-deferred. This means you don't incur any tax obligations until you receive payments. When you receive a payout from an annuity—either as the owner or the beneficiary—the amount of your payout that's subject to taxation depends on whether the annuity is qualified or nonqualified.

Because the money used to purchase a qualified annuity was not usually taxed to begin with, the entire distribution of a qualified annuity will likely be included in your income. This is the same tax treatment as any other investment held within a tax-deferred retirement account.

Payouts from nonqualified annuities are only partially taxable. Since the money used to buy the annuity has already been taxed, only the portion of the payout that's attributable to earnings will be included in your income.

How you choose to receive the death benefit is also a factor in determining the tax implications of an inherited annuity:

• Taxation of lump-sum payouts. When you take a lump-sum payout, you must include the entire taxable portion of your payout in your income in the year the distribution occurs. This is usually the least efficient payout choice for tax purposes. That's especially true if the death benefit is large enough to increase your taxable income and put you in a higher tax bracket.

• Taxation of payment streams. When the death benefit is paid out as a stream of payments, the tax liability is spread out over multiple tax years. Each payment from a nonqualified annuity includes a portion of the gain as well as the original after-tax contribution, so they're only partially taxable. The percentage amount of each payment that isn't included in your taxable income is called the exclusion ratio. For a qualified annuity, the entire payment will be reported as taxable.

If you inherit an annuity, it's important to consider taxes. In general, spreading your payments out over the longest period of time possible may result in a lower tax bill. Remember that the nonqualified stretch option allows you to annuitize the death benefit and spread it out over your life expectancy.

Inheriting an annuity can provide an excellent opportunity for you to make progress toward your goals. Before you decide what to do with your inheritance, think about your goals and how this money can help you achieve them. If you already have a financial plan in place, you can start by reviewing it and considering which goals you might want to get ahead on.

You could use the money to:

• Pay down debt more quickly
• Buy a home
• Jumpstart your retirement savings
• Increase your emergency fund
• Donate to a charitable organization you value

If you don't have a financial plan in place, consider speaking with a financial advisor about establishing one so you can make the most of your inherited annuity. Everyone's circumstances are different, and you need a plan that's customized for you. Connect with a local financial advisor to discuss your questions about inheritances and annuities.