Inherited Annuity Tax Implications

Inherited an annuity and now trying to figure out the inherited annuity tax implications?  First of all I am sorry for your loss as my family has just experienced this very scenario.    

The first thing to understand is the common feature of all annuities.  A portion of the annuity income is considered a return of your investment principle and is nontaxable. As a result, the earnings from the annuity are treated as taxable income.  

For example, let’s say the amount invested in an annuity is $10,000 and the annuity value increases to $18,000.  The return of the $10,000 is nontaxable and the $8,000 is treated as taxable income.

Inherited Annuity Tax 

When one inherits income with respect to a decedent’s assets, the decedent’s cost basis becomes your basis and you will have taxable income in the same manner as the decedent would have.  As a result, the value of the annuity you inherited exceeds the decedent’s basis is taxable income when you receive the annuity proceeds.

Contacting the investment company is the best way to obtain the basis and value of the annuity. Based on this answer you can consider the tax consequences of cashing in the annuity immediately, or continuing to utilize the tax deferral and withdrawing it over an extended period

A couple of other factors to consider is to examine the investment aspects of the annuity in terms of costs, rates of returns and how it fits into your overall investment plan.

Inherited Annuity Tax Distribution Options

An inherited annuity usually has three distribution options:

  • Take a lump sum

Annuity beneficiaries may choose to take the proceeds of the contract as a single lump sum. This election results in an immediate increase in your taxable income for that year. The entire amount of the proceeds, over the basis, paid to you as a lump sum are considered taxable earnings.

  • Take the annuity over a five year period

The insurance company will arrange equal and systematic payments on a regular basis so that the entire balance of the account is paid out in five years. The portion received during the year is added to your taxable income and the remainder will continue to accumulate tax-deferred.

  • Take the income over your lifetime

If you are the beneficiary of your spouse’s annuity, you have have the option to continue the contract in your own name. Upon your spouse’s death, the insurance company can re-title the account into your name.  This will allow you to maintain its tax-deferred status. There will not be taxes due at the time of the transfer and the contract will continue with existing applicable retirement withdrawal rules. The option to continue an annuity as your own is only available if your spouse was the contract owner.

Final Note on Inherited Annuities Tax Situations

If the decedent was already receiving payments, you will be required to take the payments at least as rapidly as they were taking them. Please pay attention to all options and instructions that you receive from the investment company regarding the annuity.  Unfortunately, annuities come in a variety of forms and fee structures.  

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  • Leigh anne truitt

    Thanks for going into the specific options for annuity tax distribution options. Would you say the options are also dependent on the original contract?

    Out of the three options for an inherited annuities, what options tend to be the most popular? Each one is positive in their own right, but I am curious as to which one people tend to go for.

    I also read on Annuities HQ: http://www.annuitieshq.com/articles/distribution-options-inherited-annuity/
    about the ‘period certain’. That if the contract is for 10 years and the loved one dies at year 8 of the contract, then the beneficiaries would receive 2 years of income, or they could do a one time payout. In this circumstance, could a one time payout push you into another tax bracket?

    Curious to hear what you think!