Tax deferred annuities are investment contracts offered by insurance companies that grow free from tax until owners go to withdraw funds. Annuity contracts typically guaranteed returns that are backed by the credit of the issuing company, and tend to be popular among more conservative and older investors. Although the primary feature of an annuity contract is the option to receive guaranteed monthly payments for the remainder of the owner’s life, regardless of how long she lives, sometimes annuitants pass away before using their entire annuity. Understanding the tax implications of inheriting a tax deferred annuity lessens the shock of the tax bill that comes along with one.
Most annuitants purchase tax deferred annuities with after-tax funds, and establish a basis in the policy. Although income from annuities is taxed as ordinary income, policyholders recover their basis tax free. Annuities pass from owner to beneficiary by contract, so unlike other investments they receive no step-up in basis during the settling of the estate, but instead the beneficiary inherits the owner’s remaining basis in the policy.
Settling the Estate
Annuities pass from owner to beneficiary by contract, so most tax deferred annuities avoid estate taxes by paying out directly to the heir. However, some policyholders designate their estates as the beneficiary of the policy. While this seems to lose the benefit of passing the balance by contract, if the owner is in a lower tax bracket than the intended beneficiary it will provide a tax benefit. Because annuities are taxed as ordinary income, the deferred growth could be taxed at the 15 percent rate rather than, for example, at the 35 percent rate. Policyholders whose estates are larger than the estate tax exemption can reduce the size of their total estate by having annuities pay to named beneficiaries rather than into the estate.
The only federal tax on the deceased’s estate is the federal estate tax, which exempts the first $5 million adjusted for inflation. States may levy taxes on the deceased’s estate, or on the inheritance received by the heirs. Depending on your state’s laws, estate and inheritance taxes may include annuity proceeds. Typically, contractual payouts such as annuity proceeds are not subject to inheritance taxes; however, tax laws consistently change, especially in times of shrinking government budgets.
Under most scenarios, the only taxes due on a tax deferred annuity you have inherited would be ordinary income tax on the untaxed growth. Subtracting the decedent’s basis from the total death benefit of the policy provides the untaxed growth. You must include any untaxed growth that you receive as part of the inheritance of a tax deferred annuity in your gross income. The insurance company keeps track of the owner’s basis, and must issue a Form 1099 for the amount that you must include as gross income, which is taxed at your marginal tax rate.
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