Annuities are designed to help investors protect against the risks of outliving their money. But not every annuity gets beyond the accumulation phase, when contract holders make deposits into their account. When the person who took out the annuity dies before the annuity begins making payments, the entire balance in the account passes on to the listed beneficiaries. The tax treatment of the inheritance varies depending on several conditions.
Investors can open annuities as a qualified retirement plan, such as an individual retirement annuity. While qualified annuities provide additional benefits, such as deductible contributions, they come with additional stipulations. Starting at age 70 and a half, owners of individual retirement annuities must begin taking minimum distributions set by the Internal Revenue Service. Nonqualified annuities, those not established as qualified retirement plans, offer tax-deferred growth, and investors can keep money in the contract indefinitely.
Tax Treatment of Gain
Although some annuities operate as managed investment accounts, payments from annuities are treated as ordinary income for tax purposes. This ordinary income treatment passes along to the inheritor of an annuity as well as the original owner.
Annuities typically pass to beneficiaries by contract and do not get locked up in probate. However, annuities are included in the deceased’s taxable estate. Federal estate taxes typically exempt the vast majority of estates, applying only to significant estates, such as those worth more than $5 million. States may have their own estate taxes that apply at lower levels, or they might have no such taxes. While annuities can contribute to the size of the taxable estate, it’s the responsibility of the estate’s executor to pay any tax owed.
Some states levy inheritance taxes on taxpayers based on the amount of the inheritance received. The inheritor receiving the annuity must file the appropriate state tax forms to report inherited income. Federal tax law taxes the transfer of wealth from one generation to the next only at the estate and does not have a separate inheritance tax.
Return of Principal
Before the annuity owner died, she purchased the annuity with money that had already been taxed. The after-tax cash put into the contract, referred to as the basis, can come back out tax free. Any growth in excess of the basis is taxable income for the inheritor. Certain steps can mitigate the taxation of nonqualified annuities inherited by a spouse, such as adding both spouses as owners and transferring the annuity into the surviving spouse’s name. Otherwise, even if the inheritor wants to use the inheritance to open an annuity, he must first pay tax on the growth and then use the remainder to fund the new annuity.
Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.