Annuities offer long-range savings for the security-minded investor. While one of the most powerful opportunities that an annuity offers is the option to convert it into a steady income stream, many people pass away without exercising that option. When that happens, the insurance company pays the unpaid account balance to beneficiary listed on the policy. This feature allows you to get the money without it having to go through probate. You might still have to pay taxes on it, though.
Income Tax Issues
Funds inside of an annuity can grow tax-deferred. You don’t pay tax on your growing account balance, just when you withdraw the untaxed portion. The untaxed portion usually comes out first when you make a withdrawal, because money in an annuity is accounted for on a last-in, first-out basis. When you inherit an annuity, you assume the owner’s basis -- the amount of already-taxed money -- in the account. You’ll recognize the same amount of income from the annuity as the owner would have. Most states follow the same rules for determining income from an annuity, but some states deviate from the federal tax treatment.
Transfer Tax Issues
Federal tax law only imposes an estate tax on wealth passed down at death. If the annuity owner still had ownership when he died, the value of the annuity is included in his taxable estate. The amount excluded from estate tax -- $5,250,000 as of publication -- ensures that very few estates will owe federal tax. States set their own rules. Several states have estate taxes with far lower exclusion amounts. Some states also impose a tax on the amount you inherit from the estate. Only Maryland and New Jersey impose both at the time of publication.
Inheriting an Annuity
When the annuity owner dies, the insurance company will pay the remaining benefit out to the listed beneficiary. If you’re the listed beneficiary, you have some options on how to receive the benefit and might be able to stretch payments out over your remaining lifetime. Only if you’re the annuity owner’s surviving spouse can you have the annuity transferred into your name without any tax implications.
Should you elect to stretch the payments out over several years or the duration of your life, you will report a portion of each payment as taxable income. The rest you can get tax-free as a return of the deceased’s principal. You calculate those portions using the exclusion ratio, which is the amount of after-tax money in the annuity divided by the anticipated payout. If you take payments over the rest of your life, you calculate the anticipated payout using Internal Revenue Service tables. You multiply the amount of the payment by the exclusion ratio to find the amount of each payment you don’t include on your tax return.
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