What is a stretch annuity?
Did you know that in certain circumstances you can pass along more than just your annuity’s death benefit to an heir? Certain types of annuities offered by a handful of insurance companies can be set up to provide multi-generational payouts.
This approach is often referred to as a stretch annuity provision, or simply a stretch annuity. You may also see it referred to as a legacy annuity. The concept is that the annuity contract can be “stretched” over multiple generations instead of just a single owner or couple.
A stretch annuity option is one designed to benefit the beneficiaries of the annuity once the owner passes away. It provides tax-deferred allowances and allows the beneficiary(s) more flexibility and control over maintaining the contract.
In most cases, annuity death benefits are taxable income. The amount of this death benefit might be the current cash value of the annuity or some other amount based upon contract riders that the owner purchased. The tax on death benefits depends on a number of factors.
There is also typically a provision, known as the five-year rule, that requires the entire balance of the annuity is distributed to non-spouse beneficiaries within five years of the owner’s death, either as a lump sum or a series of payments that must end within five years.
Stretch annuities bypass the five-year rule.
How a stretch annuity works
Stretching the annuity can provide lifetime income to the owner’s beneficiary. The lifetime income amount will be based on the inherited contract value and the beneficiary’s life expectancy at the time he or she begins receiving income from the annuity.
IRS rules stipulate that beneficiaries must withdraw a minimum amount each year from the annuity based on the contract value and their life expectancy, though they can withdraw more. The first distribution must be taken within one year of the original owner’s death. The minimum distribution amount is recalculated each year. Multiple beneficiaries may each use their own remaining life expectancy to calculate their required distributions.
In addition to stretching the annuity’s income potential, this strategy also stretches the beneficiary’s tax liability over several years. Receiving an inherited annuity in a lump sum can produce a sizable tax bill depending on the amount inherited and the beneficiary’s tax bracket. For this reason, the strategy is often used by wealthy individuals to pass along part of their estates, especially if their heirs belong in high tax brackets.
Plus, the money in the annuity will continue to grow based on the contract’s interest rate and/or crediting method, and the growth will continue to be tax-deferred.
How a stretch annuity is structured
Depending on the contract provisions, you may have the option of setting up the income for your beneficiaries in one of two ways:
- A voluntary structure allows the beneficiary to decide whether or not to stretch the account or to take a lump sum distribution. If the stretch option is selected, some companies will allow the beneficiary to withdraw more than the determined distribution amount, while others do not allow ad hoc distributions or any changes to the income amount. Most allow the beneficiary under a voluntary arrangement to terminate the income payments and receive the remaining contract value in a lump sum.
- An involuntary structure is one in which the owner can restrict the method of distributing contract values to beneficiaries. Distribution options usually include a life annuity, a life annuity with guaranteed period certain, a designated period of years or a systematic withdrawal over the beneficiary’s lifetime.
A reason to choose the latter option is to prevent heirs from spending the entire annuity value too quickly. This strategy is also sometimes used when passing the annuity value to grandchildren.
It is possible for the annuity to be passed on to more than one generation. The annuity owner can select a successor beneficiary, or grant the primary beneficiary the ability to name his or her successor. Under this arrangement, if the primary beneficiary passes away before his or her life expectancy, resulting in there being remaining annuity assets, those distributions get passed on to the successor beneficiary. A common scenario is a grandparent who names a son or daughter as primary beneficiary, and that son or daughter names one of their children as the successor beneficiary. The distributions would continue to the successor beneficiary based on the life expectancy of the primary beneficiary.
The stretch provision can only be used if the beneficiary is a person. If the beneficiary is a trust, charity or estate, the five-year rule must be used to disburse the contract value after the owner’s death.
Using a stretch strategy requires careful planning, so it’s recommended you work with an advisor knowledgeable in estate planning concepts.