Clients who inherit an annuity may now have a few more options thanks to a recent private letter ruling from the IRS.

Rather than being bound by the terms of the decedent's contract, beneficiaries may be able to exchange inherited contracts for newer, higher paying contracts, according to PLR 201330016. Such an annuity might have lower costs, come from a stronger company, offer better investment options, or have desirable features.

“Advisors with clients in this situation should work with their firm’s people who are knowledgeable about annuities so that all the options can be considered,” Scott Stolz, president of Raymond James Insurance Group, the insurance general agency for the Raymond James, said.

Previously, clients would generally either elect to annuitize the contract within 12 months, or take all the money out within five years and pay tax on any deferred gains, Stolz said.

In this case, the PLR was written in response to a taxpayer whose mother had died, naming her as the beneficiary of several annuities that had not been annuitized. These annuities were non-qualified, so they were not held in a tax-advantaged retirement account.

The daughter elected to receive the payout over her life expectancy, but she discovered that she could get a new annuity from Company C with a higher payout than she’d receive from Companies A or B, the issuers of the inherited annuities.

“That’s not unusual,” said Stolz. “A client who shops around might find a better income rate than the annuitization rates offered on inherited annuities.” Today, with interest rates expected to head higher, waiting for up to 12 months to decide might deliver more cash flow from a replacement annuity.

In this PLR, the daughter arranged for an annuity from Company C; the money from the original annuities is to be sent directly to Company C by Companies A and B. The taxpayer requested that the process would be treated as a tax-free exchange, under Section 1035 of the tax code, the provision commonly used for swaps of annuities and life insurance policies. The IRS consented, provided all the requirements of a 1035 exchange are observed.

A PLR is non-binding and only applies to the taxpayer who made the request, but it also shows how the IRS regards a certain issue. Thus, an exchange for a higher-paying annuity may be a realistic option for beneficiaries.

The challenge may lie in finding an insurance company willing to issue an annuity that will conform to the rules while not imposing steep costs, Stolz explained. The PLR is so recent that it’s too early to know how insurers will react. Nevertheless, it’s not too soon for advisors to have conversations with clients who inherit annuities, revealing that trading up is now a viable strategy, he said. 

Stolz also raised another possibility, one that is not addressed in the PLR. As mentioned, non-spouse beneficiaries also have the option of waiting for up to five years, then liquidating the contract. (Spouses also can re-register the contract in his or her own name, for ongoing tax deferral.) “A beneficiary who wants the money but is willing to wait may be able to do a 1035 exchange for an annuity that could be held for five years,” Stolz said.

Register or login for access to this item and much more

All Financial Planning content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access