Do I Pay Taxes on All of an Inherited Annuity or Just the Gain?

A nonqualified annuity, which is an annuity not associated with an employer-provided plan or an Individual Retirement Account, is generally purchased with an after-tax, lump-sum investment by the owner, or "annuitant." Then, similar to other retirement plans, that original investment accumulates income that is not taxed until it is distributed. Some annuities are crosses between retirement plans and life insurance plans in that they provide a guaranteed death benefit that could be more than the value of the account at the time of the annuitant's death. No matter what the design, at some point, someone -- annuitant or beneficiary -- will be responsible for paying federal income taxes on distributions. Annuities are also included in the estate for federal estate tax calculations.

Taxation

Unlike other investments, the named beneficiary of a nonqualified annuity does not get a step-up in tax basis to the date of death. However, that doesn't mean the beneficiary will have to pay taxes on the full amount. Because the purchaser of the annuity made the investment with after-tax dollars, only the amount attributable to investment income is taxed, but it will be taxed as ordinary income and not enjoy any special capital gains treatment. When there is a death benefit that exceeds the value of the account, that additional amount is also taxed as ordinary income. Beneficiaries are not subject to the 10 percent early distribution penalty that applies to distributions before the annuity owner reaches age 59 1/2.

Distribution Requirements

Similar to an IRA, requirements specify how and when beneficiaries of a nonqualified annuity must take distributions. If the annuitant had begun taking periodic distributions before her death, the beneficiary must continue the payment option chosen by the annuitant. For example, if the annuitant chose a life and 15-year period certain annuity and died after 10 years, the beneficiary would receive the same benefit the annuitant was receiving for five more years. If payment had not begun, a non-spouse beneficiary has three choices: a lump-sum distribution within one year of the annuitant's death, full distribution within five years of the annuitant's death or periodic distributions based on the life expectancy of the beneficiary.

Calculating the Taxable Portion

For periodic payments, a portion of each payment will be considered a recovery of investment and, consequently, not taxable. This is called the exclusion ratio. For annuities with variable income, the exclusion ratio is the amount of the original investment divided over the expected payments. For a fixed annuity, the exclusion ratio is the ratio of investment to expected return. If annuity payments already had started to the deceased, then the beneficiary would have the same exclusion ratio as the deceased had. However, if the policy calls for a lump-sum death benefit, then the beneficiary would exclude from that lump sum the remaining exclusion that the original annuitant hadn't recovered.

Spouse Beneficiary

Again, as with an IRA, spouse beneficiaries often have an additional option. If the policy has a provision, spouses can take over the annuity of a deceased spouse. In this case, the spouse would not have to take an immediate distribution. Because no required minimum distribution rule exists for nonqualified annuities, the spouse would not have to make withdrawals at any point. When the annuity includes a death benefit, the spouse beneficiary usually has to choose an option. One drawback is that a spouse who takes over a deceased spouse's annuity would then be subject to the 10 percent early distribution penalty if she needed to take distributions from the inherited annuity before she reached age 59 1/2, and for early distributions, the taxable portion is removed first.