I recently learned that I am the beneficiary of an annuity from a friend in the amount of $54,845. I was given options about how to receive the money: a lump sum, rolling it over, or deferring payments for 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 get stuck paying too much taxes?
Shannon, sorry to hear about your friend’s passing. Like any question and answer asked in this kind of context, I won’t be able to tell you specifically what you should do. But I can help you formulate your situation so you can better understand what’s going on and what your options are. Hopefully, this will help you decide what is best for you. (And if you have a specific financial planning question like this, consider speaking directly to a financial advisor.)
inherited 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 you are a non-spouse beneficiary of a qualified annuity. This means that the annuity is placed in some type of retirement account such as a 401(k) or IRA. If my assumption is correct then you will have to pay income tax at your personal tax rate when funds are distributed from the account. It is important to understand this because it affects which option you should choose. (And if you want information about how your decision about an inherited annuity will affect your overall financial or retirement planning, consider working with a financial advisor).
Options for handling your inherited annuity
If you have indeed inherited a qualified annuity, whether you choose to receive the payments, take the entire amount as a lump sum distribution or roll it into an inherited IRA, there will be specific tax implications. You have to keep in mind that when you withdraw the money, it is taxed. If you choose to receive payments, each payment is included in your taxable income as soon as it is received.
Generally, from a tax standpoint, it is better to spread the distribution over time rather than taking a lump sum. However, that is not always the best path. It depends on what tax bracket you are in now and what your projected tax bracket might 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 want more advice on your tax strategy, consider talking to a financial advisor.)
Consider your goals
Although tax minimization should certainly factor into your decision, it may not be the most important factor. When you decide what to do, consider your situation and goals and choose the option that uses your inheritance most effectively. This could 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 desperate need of home repairs. If the annuity is used in a way that will help you move or get out of a financial burden when you meet one of them, then it is worth considering.
next steps
Assuming you have a qualified annuity, you’ll have to pay taxes when you withdraw the money. Depending on your net worth and other goals, you may want to spread your distributions over several years or take a lump sum. There is no single best answer that applies to everyone.
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Brandon Renfrow, CFP®, is a SmartAsset financial planning columnist and answers readers’ questions on personal finance and tax topics. Do you have 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 has been compensated for this article.
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