An annuity contract provides a stream of payments in return for one or more premiums that pay for the contract. The contract owner can pay for the annuity with a single lump-sum premium or can build up the annuity’s cash value over a defined period. The tax arising from an inherited annuity depends on the type of contract.
A qualified annuity resides in an employer retirement plan or individual retirement account. The premiums paid for a qualified annuity are tax deductible. Employer plans allow the employer to contribute to an employee’s annuity, and those contributions are tax deductible to the employer. A nonqualified annuity is a contract that the owner purchases directly from an insurance company. These premiums are not deductible. A Roth annuity is qualified but the premiums are not deductible. Roth annuities reside in employer Roth plans and Roth IRAs.
Taxes on Annuities
The general rule for annuities is that taxes are due on amounts that exceed the cost basis of the contract. An annuity’s cost basis equals the after-tax premiums contributed minus any withdrawals. Qualified annuity premiums are typically paid for with pre-tax money, therefore these annuities have no cost basis. Payments received from these contracts are fully taxable. Nonqualified and Roth annuities have a cost basis equal to the premiums paid in. The payments arising from these contracts are partially taxable.
An annuity’s death benefit is a lump sum paid out at the owner’s death. The taxable portion is the amount that exceeds the contract’s cost basis. The death benefit from a qualified annuity to a nonspouse beneficiary can be rolled into an “inherited IRA,” which is a special type of IRA only for qualified inheritances. By rolling over the death benefit, the beneficiary can stretch out the payments -- and the tax due on the payments -- over five years or longer. A spouse beneficiary can roll the death benefit into her own IRA and need not begin taking payments until reaching age 70 1/2. The death benefits from nonqualified annuities pay out right away and create an immediate tax bill on the amount in excess of the cost basis. However, the contract might allow the beneficiary to convert the death benefit to an annuity and thus stretch out the tax liability.
A survivor annuity continues to make the same or different payments to the beneficiary. These payments are partially or fully taxable, depending on the extent to which they exceed the original annuity’s cost basis. Beneficiaries of qualified survivor annuities figure the taxable portion of each payment using a simplified method that's different than the general Internal Revenue Service rules followed by beneficiaries of nonqualified survivor annuities. If the contract permits it, the survivor can pay additional premiums and increase the cost basis. This would be possible, for example, if the owner died before annuity payments began. Some annuities guarantee a minimum number of payments, even if the owner dies before the contract completes these payments. The beneficiary receives these payments and only pays tax once the cost basis is exceeded.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.