The following is adapted from Inheriting Chaos with Compassion.
Oftentimes, when a loved one passes away, we end up inheriting assets we’re not equipped to handle. For most people, a perfect example of that truth would be inheriting an employer-sponsored retirement account of an annuity from the deceased.
Not only were those retirement vehicles designed for your loved one—not you—they’re going to difficult to understand unless you’ve invested in these vehicles yourself.
In this article, we’ll look at the different types of empower-sponsored retirement accounts, define what an annuity is, and look at distribution rules for each.
Employer-Sponsored Retirement Accounts
There are several kinds of retirement accounts that can be accessed through an employer or a business. A few of the more common account types include:
When you contribute money to a 401(k), you receive a tax deduction and the money grows tax-deferred. Unlike other retirement accounts, like an IRA, contribution limits are much higher for a 401(k). As of today, people under the age of fifty can contribute up to $19,000 per year, and people over fifty can contribute $25,000 per year.
These contributions come straight off an employee’s paycheck. Additionally, most companies match an employee’s contributions up to a percentage of the employee’s salary (usually between 3–6 percent). This means that if you contribute 3 percent of your yearly income to your 401(k), your employer would put in the same amount of money you do. This type of account is designed to build assets.
SIMPLE Plans, Solo 401(k)s, and Defined Benefit Plans
These plans are typically used by self-employed people to put money aside for retirement on a tax-deferred basis, though Defined Benefit Plans can also be used by large corporations, something that used to be common practice, but is now largely being phased out.. Larger contributions are allowed in these types of accounts than in standard, traditional IRAs. Like other retirement plans, these accounts have penalties for early withdrawal, as well as distribution requirements.
Participants in Defined Benefit Plans funds have a variety of options for how payouts are distributed; for example, they can elect to have a percentage of their payout go to a spouse.
These elections also affect the way those funds are inherited. If you’re setting up or are a participant in a larger defined-benefit plan, it’s important to know the elections available to you, and a financial advisor can guide you to make the elections that match your needs.
Simplified Employee Pension (SEP)
This is another type of self-employed retirement plan, with the same contribution limits as a traditional IRA, at $6,000 (up to age fifty) and $7,000 (over age fifty)
Business contributions can be higher on a SEP plan.
403(b), 457, and variations
These plans function the same way that 401(k) plans do, but they are set up for government employees and educational institutions.
They allow much higher contributions than SIMPLE and SEP plans, and they are eligible for matches from an employer.
These accounts typically get transferred into a traditional IRA when they’re inherited so heirs can manage their account without going through their loved one’s employer.
Employers may have limited options for investments, and they may require you to go through their human resources department to make any changes or distributions.
Additionally, there are usually fees associated with these accounts. While the employee holds the plan, the corporation or the employee are often responsible for administration costs, but an heir may have to cover all the costs of an inherited plan themselves.
For these reasons, it’s more favorable to transfer these accounts into IRAs and consolidate assets into whichever custodian you prefer. This gives you investment choices, greater control, and no need to go through an HR department.
An annuity is an insurance contract for an investment. Annuities can be part of an investment plan within an IRA, and they have the same distribution rules as an IRA.
However, they can have additional barriers to access the investments, called “surrender periods,” usually seven to ten years long, that restrict when you can take money out of these accounts. During the surrender period there are “surrender charges,” which are additional monetary penalties for taking money out of the account.
There are appropriate times to use annuities in an investment portfolio, but I sometimes see clients pushed into high-commission annuities that trapped their investments.
In one case, my client Barb inherited money from her mother in the form of a taxable account, but she didn’t know what to do with the money. A broker sold her an annuity. Barb didn’t understand the distribution rules and tax treatments around this product and locked the money away from herself for several years because of the surrender charge.
When Barb came to me, we discovered that there was a high fee structure on her annuity, which meant that the growth of her investments was stunted. She wasn’t seeing the amount of growth she wanted to compensate for the fees on the account.
Although she was very frugal with her money, Barb needed her mother’s inheritance to complete renovations to her house, but she couldn’t access it. To improve her access to the money, we rolled this account into a low-fee annuity with no surrender charge. She still didn’t have great access to the money, but we could take out a little bit at a time without inflating her income too much with the gains on her growth. It took about five years to get out of the annuity without destroying her tax returns.
Often, scenarios like Barb’s happen because clients are overwhelmed with grief. Barb had made her initial decision to buy the annuity because she thought she needed to act fast with her mother’s money, and it was difficult to take the proper time and consideration to understand what she was buying. A client’s internal compass may tell them something is off, but they don’t know what else to do. Annuities can be particularly tricky financial products because their fee structures and rules are so variable.
It’s important to be able to clearly understand the fees, distribution requirements, and tax structure of your investments. Because an annuity is a contract for an investment with an insurance company, each contract stipulates the particulars of that purchase.
Below we’ll cover some of the general guidelines, but if you’re considering including an annuity in your investments, it’s important to understand the fine print of your contract.
Annuities come in two types: variable and fixed.
With fixed annuities, the owner has a guaranteed, fixed monthly income once they start taking distributions. For example, you may pay $500,000 into an annuity in exchange for receiving a fixed $5,000 payment per month for the rest of your life.
Usually with fixed annuities, when the owner dies, the policy dies with them; those payments are not passed on to an heir. If only $60,000 of the $500,000 was paid out over the owner’s lifetime, the company holding the annuity keeps the remainder.
Because of this, fixed annuities are typically not inherited.
However, there are many different ways to set up an annuity, and some of those structures can be passed on. For example, if a loved one has purchased a product called a “ten-year certain,” the insurance company will continue to pay the owner or their beneficiary the fixed payment for ten years.
Then there are after-tax annuities, which have looser requirements for when money can be taken out. Money is paid into after-tax annuities after income tax is taken out. When distributions are taken, taxes are applied only to the growth of the investments.
This gives these after-tax annuities more flexibility in their distribution rules, and the contract will stipulate terms for distributions and when penalties apply.
You Don’t Have to Figure It Out Alone
As you can see from this article, employer-sponsored retirement accounts and annuities can with unique stipulations and wrinkles that make them difficult for newcomers to understand, much less put to work to achieve their financial goals.
If you inherit either of these types of accounts, don’t be afraid to seek help from a financial advisor who can explain how things work in much more detail.
For more advice on handling inherited retirement accounts, you can find Inheriting Chaos with Compassion on Amazon.
Jennifer Luzzatto is a Chartered Financial Analyst®, a Certified Financial Planner®, and a NAPFA registered financial advisor. She began her career in financial services thirty years ago as a fixed-income trader in a regional brokerage firm and went on to manage personal trust accounts, institutional portfolios, and a municipal bond mutual fund at a commercial bank. In 1999, she founded Summit Financial Partners, transitioning from banking to financial planning and investment advisory services. Jennifer holds a BA in Psychology and an MBA from the University of Richmond. She lives in Richmond, Virginia, with her daughter and their dog.