Helping An Annuity Beneficiary Understand Distribution Options
April 28, 2015 by Thomas H. Duncan, JD, CLU, ChFC Director, Nationwide Advanced Consulting Group
When the owner of a nonqualified deferred annuity dies and leaves the money to a nonspouse individual beneficiary, that beneficiary has several different distribution options:
• Five-year Rule
• Nonqualified Stretch
• Annuitization
Five-year Rule
The five-year rule requires that the entire balance of the annuity be distributed within five years of the owner’s death.
The beneficiary may:
• Take all the proceeds soon after the death of the owner
• Take discretionary amounts out at any time during the five-year period
• Wait until the fifth year to take out all the annuity proceeds
Regardless of how the beneficiary chooses to apply the five-year rule, their annuity income will be taxed to the extent of gains distributed from the contract, and gains are distributed first.
If a trust, charity or estate is the beneficiary of a nonqualified deferred annuity, the five-year rule is the only distribution option available.
Nonqualified Stretch, a.k.a. The Life Expectancy Method or One-year Rule
This is similar to the stretch or extended IRA concept, where the beneficiary uses his or her remaining life expectancy to calculate an annual required minimum distribution.
This can be characterized as a systematic withdrawal over life expectancy.
A combination of factors may make this option advantageous:
• Market exposure in variable subaccounts
• Continued tax deferral of the cash value
• Smaller income tax bills by taking only the required minimum distributions
Compared to other distribution options like the five-year rule or annuitization, these factors may create more money over time for the beneficiary. Some important points to consider are:
• The first required minimum distribution from a nonqualified annuity must be taken within one year of the date of the annuity owner’s death
• In each subsequent year, the beneficiary must take at least a life expectancy-based required minimum distribution by December 31
• The beneficiary’s initial life expectancy factor is determined using the IRS Single Life Table and then one (1) is subtracted from that life expectancy factor for each subsequent year—35, then 34, then 33 and so on
• The beneficiary is not limited to taking only the required minimum amount; he or she may take more, up to the entire cash value
• The beneficiary, as the owner of this now-beneficial nonqualified annuity, determines the investment options, so he or she bears the investment risk with this option and determines the date of the yearly required distributions
• The beneficiary is the taxpayer on the gains of the annuity, and the gains are taxed first
• Multiple beneficiaries may each use their own remaining life expectancy to calculate the required distributions (if separate beneficial annuities are created for each beneficiary)
• The beneficial owner may name a successor beneficiary who can finish taking the required minimum distributions if the beneficial owner dies prior to the complete distribution of the annuity’s cash value
• The successor beneficiary does not use his or her own life expectancy, but instead continues to calculate the required distributions using the remaining life expectancy of the first beneficiary
• Not all annuity carriers permit the systematic withdrawal over life expectancy option for beneficiaries
Annuitization
The beneficiary may also annuitize the proceeds of the nonqualified annuity. Any available single-life payout option or a term-certain-only option that is shorter than life expectancy may be used. Annuitization transfers the investment risk from the beneficiary to the insurance company in exchange for the guaranteed income stream. Also, because this is annuitization, the beneficiary has the benefit of the exclusion ratio treatment on distributions:
• During the beneficiary’s life expectancy, part of the income payment will be treated as a gain and part will be treated as basis
• If the beneficiary lives beyond his or her life expectancy, the remaining distributions will be treated at 100% gain
As you can see, nonspouse individual beneficiaries have many different distribution options with nonqualified annuities. If the beneficiaries are looking for ways to potentially grow the proceeds of the annuities left to them and lessen their tax burden on a year-over-year basis, then the nonqualified stretch annuity concept may be an attractive option to consider.
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Federal tax laws are complex and subject to change. This information is based on current interpretations of the law. Nationwide and its representatives do not give legal or tax advice. Your clients should talk with their attorney or tax advisor for answers to their specific questions.
Nationwide Life Insurance Company or Nationwide Life and Annuity Company, Columbus, Ohio. The general distributor is Nationwide Investment Services Corporation, member FINRA.
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