The death of a loved one who sought to pass down an annuity poses a time-sensitive decision on the beneficiary, with massive tax implications.

The potential tax liability to clients may climb as high as hundreds of thousands of dollars if they elect for a lump-sum distribution when inheriting a non-qualified deferred annuity, according to Laird Johnson, the senior director of advanced markets for AXA Distributors.

Indeed, in that scenario, they would pay full income taxes on any earnings, Johnson says, and they may not know their other options.

The issue “creates a challenge as people are trying to sort out the affairs of a deceased parent or grandparent,” he says. “They have to move it over within 12 months. It’s really that beneficiary taking that first distribution which really cements what kind they’re taking.”

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Tax boon for clients: Funds that sidestep AMT
If your clients pay the alternative minimum tax, these funds can help lower their tax liability.

‘HAVE YOUR CAKE AND EAT IT TOO’
Other options include the so-called stretch option, which spreads out the distribution over their life expectancy and allows the beneficiary to control when the funds are subject to taxes. Funds that remain in the annuity keep growing on a tax-deferred basis under the control of the beneficiary.

Clients in their 50s and 60s should understand that they’re likely to wind up in a lower tax bracket if they wait until they are older to receive the distributions, according to Johnson.

A 1035 exchange provides another path for beneficiaries if the inherited annuity doesn’t look like a good fit. While Johnson says inherited contracts wouldn't be eligible for transferring into a long-term care insurance policy, clients do have other options.

AXA’s Investment Edge variable annuity carries daily fees of up to 75 basis points for operations, 30 basis points for administration and 20 basis points for distributions. However, the product also includes more than 120 investment options for the beneficiary, Johnson points out.

“They still control how the assets are invested,” he says. “But they get the tax benefits of annuitization. We like to say it’s kind of like having your cake and eating it too.”

Tobias Salinger

Tobias Salinger

Tobias Salinger is an associate editor of Financial Planning, On Wall Street and Bank Investment Consultant.