July 25

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How Are Inherited Annuities Taxed? All You Need to Know!

By Harrison O'Reill

July 25, 2023


If you’ve inherited an annuity, you may be wondering how it’s taxed. The answer is that it depends on a few factors, including the type of annuity and your relationship with the original owner. If the annuity was a qualified annuity, meaning it was purchased with pre-tax dollars, then the entire amount will be subject to income tax when you withdraw it.

However, if the annuity was a non-qualified annuity, meaning it was purchased with after-tax dollars, then only the earnings portion will be subject to income tax. Additionally, if you’re the spouse of the original owner and you choose to treat the annuity as your own, you may be able to defer taxes until you begin taking withdrawals. It’s important to consult with a financial professional to determine the tax implications of your specific situation.

Overall, understanding how inherited annuities are taxed is crucial for making informed decisions about your retirement income. By knowing the type of annuity and your relationship to the original owner, you can better plan for taxes and maximize your financial benefits.

Inherited Annuities

Inherited annuities are annuities that are passed down to beneficiaries after the death of the original annuitant. An annuity is a financial product that provides a steady stream of income over a predetermined period of time. Inherited annuities are typically passed down to spouses, children, or other family members.

How are Inherited Annuities Taxed?

The taxation of inherited annuities depends on several factors, including the type of annuity, the age of the original annuitant, and the age of the beneficiary. If the original annuitant was over the age of 59 ½ at the time of their death, the beneficiary could take distributions from the inherited annuity without incurring a penalty. However, the distributions will be subject to income tax.

If the original annuitant was under the age of 59 ½ at the time of their death, the beneficiary may be subject to a 10% penalty on any distributions taken from the inherited annuity. Additionally, the distributions will be subject to income tax.

If the beneficiary chooses to take a lump-sum distribution from the inherited annuity, the entire amount will be subject to income tax in the year it is received. However, if the beneficiary chooses to take distributions over time, the amount of each distribution will be subject to income tax in the year it is received.

In some cases, the beneficiary may have the option to transfer the inherited annuity into their own name. This is known as a spousal rollover or non-spousal transfer. If the beneficiary chooses to do this, they will be subject to the same tax rules as the original annuitant.

In conclusion, inherited annuities can be a valuable source of income for beneficiaries, but it is important to understand the tax implications before taking any distributions.

Taxation of Inherited Annuities

When you inherit an annuity, you may be wondering how it will be taxed. The taxation of inherited annuities depends on several factors, such as the type of annuity, the owner’s age at the time of death, and the beneficiary’s relationship with the owner. Here’s what you need to know about the taxation of inherited annuities.

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Ordinary Income Tax

In most cases, the distribution from an inherited annuity is subject to ordinary income tax. The amount of tax you owe depends on your tax bracket. If the annuity was a qualified annuity, meaning it was purchased with pre-tax dollars, then the entire distribution will be subject to ordinary income tax.

However, if the annuity was a non-qualified annuity, meaning it was purchased with after-tax dollars, only the portion of the distribution that represents earnings will be subject to ordinary income tax.

Capital Gains Tax

If the annuity was a non-qualified annuity and the owner held it for more than a year before their death, then any gain in the value of the annuity will be subject to capital gains tax. The amount of tax owed will depend on the owner’s basis in the annuity and the beneficiary’s tax bracket. If the annuity was a qualified annuity, then any gain in the value of the annuity will be subject to ordinary income tax.

Estate Tax

If the owner of the annuity had a taxable estate, then the value of the annuity may be subject to estate tax. However, the estate tax exemption is quite high, so most people won’t have to worry about this.

Taxation of Non-Spousal Inherited Annuities

If you inherit an annuity from someone who is not your spouse, you will have to pay taxes on the money you receive. The amount of tax you pay will depend on several factors, including the type of annuity you inherit and how you choose to receive the money.

Lump-Sum Payment

If you choose to receive the money from the annuity as a lump sum, you will have to pay taxes on the entire amount in the year you receive it. This could result in a large tax bill, especially if the annuity has been growing for many years. You may also be subject to a 10% early withdrawal penalty if you are under the age of 59 1/2.

Stretch IRA

If you want to avoid a large tax bill, you may choose to take advantage of the “stretch IRA” option. This allows you to receive the money from the annuity over a period of time rather than all at once. By doing this, you can spread out the tax liability over several years, which may help reduce your overall tax bill.

To take advantage of the stretch IRA option, you will need to set up an inherited IRA and name yourself as the beneficiary. You can then choose to take required minimum distributions (RMDs) from the account each year based on your life expectancy. The amount of the RMD will be taxed as ordinary income in the year you receive it.

It’s important to note that the stretch IRA option is only available if the annuity was inherited from someone who was not your spouse. If you inherited an annuity from your spouse, you have the option to roll it over into your own IRA and defer taxes until you start taking distributions.

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Taxation of Spousal Inherited Annuities

To explain the taxation of spousal inherited annuities, read the following points below:

Rolling Over the Annuity

If you inherit an annuity from your spouse, you have the option to roll it over into your own IRA account. By doing so, you can defer taxes until you start taking distributions. However, you must complete the rollover within sixty days of receiving the funds to avoid paying taxes on the entire amount.

Purchasing a New Annuity

Another option is to use the funds to purchase a new annuity in your name. This would allow you to continue receiving regular payments while deferring taxes until you start taking distributions. However, be sure to compare the fees and benefits of the new annuity with those of the inherited annuity before making a decision.

Taxation of Distributions

If you choose to take distributions from the inherited annuity, the amount you receive will be subject to income taxes. The tax rate will depend on your tax bracket at the time of distribution. Additionally, if you are under age 59 ½, you may be subject to a 10% early withdrawal penalty.

Required Minimum Distributions

If you inherit an annuity from your spouse and you are the sole beneficiary, you have the option to treat the annuity as your own and delay required minimum distributions (RMDs) until you reach age seventy-two. However, if you choose to take distributions, you must take RMDs based on your own life expectancy.

Conclusion

Inheriting an annuity can come with many tax implications that you need to be aware of. The tax rules vary depending on the type of annuity you inherit, the age of the original annuitant, and your relationship to the annuitant. Here are some key takeaways to keep in mind.

If you inherit a non-qualified annuity, you will owe income tax on any earnings when you withdraw money from the annuity.

If you inherit a qualified annuity, such as an IRA or 401(k), you will owe income tax on any withdrawals you make, just like the original annuitant.

If you inherit an annuity from a spouse, you have more options and can potentially delay paying taxes until you start taking withdrawals.

It’s important to consult with a financial advisor or tax professional if you inherit an annuity to ensure you are following the correct tax rules and making the most of your inheritance. By understanding the tax implications of inherited annuities, you can make informed decisions that will help you maximize your retirement savings and minimize your tax burden.

Frequently Asked Questions

Here are some common questions about this topic:

How are inherited annuities taxed?

When you inherit an annuity, you may be subject to income tax on the payments you receive. The tax treatment of an inherited annuity depends on several factors, including the type of annuity, the age of the original annuitant, and the age of the beneficiary.

What is the difference between a non-qualified and a qualified annuity?

A non-qualified annuity is funded with after-tax dollars, while a qualified annuity is funded with pre-tax dollars. This means that the tax treatment of the two types of annuities is different. When you withdraw money from a non-qualified annuity, you will owe taxes on the earnings. With a qualified annuity, you will owe taxes on the entire amount of the withdrawal.

Can I avoid paying taxes on an inherited annuity?

Unfortunately, there is no way to avoid paying taxes on an inherited annuity. However, you may be able to spread out the tax liability over several years by taking distributions over time instead of taking a lump sum payment.

What happens to an inherited annuity if the beneficiary dies?

If the beneficiary of an inherited annuity dies before the annuity is fully distributed, the remaining payments may go to a contingent beneficiary. If there is no contingent beneficiary, the remaining payments may go to the estate of the original annuitant.

What should I do if I inherit an annuity?

If you inherit an annuity, it is important to understand the tax implications and your options for taking distributions. You may want to consult with a financial advisor or tax professional to help you make informed decisions about your inherited annuity.

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