Option 1: The 5-year rule — a fast but taxing choice
One option available to Sarah was the 5-year rule, which required her to withdraw all the annuity’s funds within 5 years from the date of her father’s death. She had some flexibility: She could take it all at once, spread the withdrawals out over the 5-year period or wait until the last year.
The downside? Taxes. Any gains in the annuity would be taxed as ordinary income in the year they were withdrawn, and gains would come out first. Taking a large sum at once could push Sarah into a higher tax bracket, resulting in a bigger tax bill. While this option offered a quick resolution, her financial professional pointed out that she didn’t need immediate access to the funds.
Option 2: Annuitization — a steady but inflexible income stream
Another option was annuitization, which would convert the annuity into a series of regular payments over Sarah’s life or a set period no longer than her life expectancy. This choice would provide Sarah with predictable income. Plus, part of each payment is a return of her father’s original investment and part is taxable gain, which is known as exclusion ratio treatment.
The catch? Once Sarah chose annuitization, there would be no possibility for the payments to increase and she couldn’t withdraw extra funds if she needed them. Her financial professional flagged this lack of growth and flexibility as significant drawbacks compared with the nonqualified stretch.
Option 3: The nonqualified stretch — maximizing growth and managing taxes
The final option, the nonqualified stretch, offered a balance between long-term growth and tax efficiency. Instead of taking the money all at once, Sarah could stretch withdrawals over her life expectancy similar to annuitization, but unlike annuitization, she'd keep the funds invested and accessible if she wanted to take more than the minimum annual required distribution. However, the tax treatment of nonqualified stretch distributions is different than the annuitization.
Nonqualified stretch distributions follow the “gains first” rule. This may mean each distribution is fully taxable: the extent of gain in the annuity instead of the part taxable/part nontaxable treatment of the annuitization option’s exclusion ratio.
Sarah must take her first nonqualified stretch life expectancy-based payment within 1 year of inheriting the annuity and then annually thereafter. Her initial life expectancy is taken from the IRS Single Life Table, and 1 year is subtracted from the prior life expectancy factor used for each subsequent year. After the required distribution is taken, the remainder of the annuity’s contract value may continue growing tax-deferred.
This approach had several advantages:
- More tax control — By spreading withdrawals over many years, Sarah could avoid a large, upfront tax bill and potentially stay in a lower tax bracket.
- Continued growth — The remaining balance could keep earning interest or investment returns.
- Flexibility — While she had to take the minimum required amount each year, she could withdraw more if needed.
For Sarah, the nonqualified stretch made the most sense. It allowed her to preserve and grow her father’s legacy while keeping her tax burden manageable.
Why this matters for your clients
If you advise clients who inherit a nonqualified annuity, you may need to read the full article to better help them navigate their options. Many may be unaware that they aren’t required to take a lump-sum payout and that stretching distributions can significantly benefit them over time.
Here’s how you can guide them:
1. Assess their needs. Review their financial situation, tax bracket and future income needs before recommending a strategy.
2. Explain their options clearly. Walk them through the pros and cons of each payout method, highlighting long-term implications.
3. Tailor recommendations. No two clients are alike. Some may need immediate funds, while others benefit from stretching distributions.
4. Help with implementation. Once they choose a strategy, ensure that they take the right steps to execute it efficiently.
The bigger picture: Honoring a legacy
For many beneficiaries, an inherited annuity represents more than just money. It’s also a legacy of hard work and planning. The right distribution choice ensures that the legacy continues to provide financial security for years to come. By educating your clients about the nonqualified stretch and other options, you empower them to make informed decisions that align with their long-term goals.
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