Tax Consequences to the Annuity Beneficiary
Annuities are especially attractive to retirees because they assure an income for life. They’re often held as deferred annuities as a back up for those later retirement years as a supplement to other retirement income or when savings become depleted. But many retirees will die before tapping their deferred annuity. What are the tax consequences to the annuity beneficiary and should other options be arranged?
A deferred annuity offers a distinct tax-benefit. It’s earning grow tax-deferred. For the same annual return as a taxable investment, a tax-deferred investment compounds faster because none of the earnings are taxed away each year. However those tax-deferred earnings will eventually be taxed upon withdrawal, whether by you or the annuity beneficiary. Your contributions to the annuity, though, will not be taxed. This is the case in ‘nonqualified’ annuities which are funded with after tax contributions.
Annuitant’s taxation
If a partial withdrawal is made, the IRS presumes that earnings come out first – so that these are completely taxable. But under regular monthly payments – a portion of each payment is not taxed but treated as a return of your nontaxable contributions. An exclusion ratio calculated by the insurance company designates that untaxed portion. When, after some number of payments and you’ve received all your contributions, all future payments will be fully taxed as income.
Beneficiary taxation
After tax contributions made by the deceased owner will remain untaxed when received by the beneficiary. And of course, all those tax-deferred earnings within the annuity will be taxed as ordinary income to the beneficiary.
Usually, if the annuitant had begun receiving lifetime payments, no benefits would be left for the annuity beneficiary. But if the contract called for a fixed term guaranteed payments, the beneficiary would received those remaining payments taxed at the deceased’s exclusion ratio.
If the annuity owner died before beginning annuitization, provision may be made for either a lump sum distribution or a series of payments. For the lump sum payment, the beneficiary would only pay tax on the earnings portion.
But in the case of a series of guaranteed payments, the beneficiary would not be required to pay taxes on any of the payments until the deceased owner’s contribution were fully received. Any payments beyond that would be fully taxed as ordinary income.
An annuity beneficiary, who earns a substantial income already, can lose a lot of that taxable portion of the annuity as he’s pushed into a high tax bracket. So, if annuity owner decides not to annuitize, he may use his annuity’s value to switch to another option better suited to his beneficiary.
Note: Annuities once annuitized cannot be surrendered for value. Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty. Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.
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January 30th, 2009 at 1:33 am
Thanks for shedding some light on a complicated subject. My father has an annuity and because of the difficult economic situation he wants to start taking money out now. I am trying to convince him that he should let it continue to grow tax free.
February 2nd, 2009 at 3:05 pm
Great article,,My Aunt died leaving my wife $30k, fixed ING annuity , they sent 1099-r with whole annuity amount as taxable instead of just earnings. I thought that was wrong, gonna make a call! Her premium was $21k will only pay tax on gain right?
February 8th, 2009 at 11:33 am
Maybe someone can help me. I was left an annuity from my aunt a couple years back. Is there any way I can use that money for a down payment on a house and not be penalized? Thanks.
February 17th, 2009 at 9:41 am
On death of annuitant, what is the maximum amount of time that can pass before the beneficiaries must begin to withdrawal process? Thank you.
February 23rd, 2009 at 9:19 am
some answqers to questions:
1. if you are the beneficiary of an annuity and that annuity was a qualified annuity(meaning, the money came from an IRA or company 401k or pension plan), the ENTIRE balance is taxanbe to you.
2. If you are the beneficiary of a non-qualified annnuity (meaning that the original source of funds was plain old savings), you have up to 5 years to take all of the funds out and pay the tax due on the accumulated earnings
3. no matter what you use the money for, #2 above still applies
March 5th, 2009 at 11:25 pm
Good post. Some things i never considered would be the extra forms to file for taxes. Sounds like ones used for partnerships or mlps. I would suggest people talk to accountant because alot of people do not undertsnad how to figure what is taxable and what is not.
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July 18th, 2009 at 10:32 am
The value of an inheritance or gift is not taxed to the recipient, but any earnings on the money would be taxed as ordinary income. The company paying the annuity would break down the income portion and return of investment portion generally, but if you inherited it you would need a CPA to help you determine the taxable amount.
September 17th, 2009 at 3:34 am
The Tax Club helped me in determining the areas where my money could be safe and could help me after retirement. Annuity is one of them and I’m certainly enjoying my retirement.
February 23rd, 2010 at 1:22 pm
This is a great article on a very important subject. Too many times people create a huge nest egg, that ends up being tax prone and in the case of an early death causes the beneficiaries to pay out an enormous portion of the benefits in the form of taxes. One of the most important parts of a successful retirement account is making sure it is as tax friendly as possible!! Great article.
March 31st, 2010 at 5:52 am
Need advice from the tax guru’s here:
I inherited my mother’s variable annuity when she died in 2002. At the time I decided to keep it because I was in a relatively high tax bracket, therefore it seemed attractive to permit continued tax deferred growth, and the investment choices were quite broad.
Over the ensuing years the value of the account nearly doubled. But over the past year the value has fallen to slightly less than what it was when I inherited, thus my cost basis is lower than the current value.
The period which involved surrender charges is long since over. I am now retired and in a lower tax bracket.
Am I correct in my understanding that if I cash this annuity out, I will not owe any income tax, since the value is less than my cost basis (the value at the date of my mother’s death)?
This seems like a good idea at this time, since there has been no benefit of tax deferral (zero or slightly negative growth over 7 years), the annuity carries higher fees than comparable funds at Vanguard, and I have a need to replenish my cash reserves that I use to augment our pension income. This seems like a better approach than selling equities or funds from my taxable accounts which have gains.
What do you think?
April 21st, 2010 at 4:30 am
Thanks for sharing this information. I’m coming upto retirment and I have to admit i find the idea of annuities quite confusing, this post has helped though.
May 20th, 2010 at 10:46 am
Question: My Uncle passed away and my Dad was named beneficiary on my Uncles annuity, unknown to my Dad at the time. Within the five year period, my Dad passed leaving everything to his nine (9) children. My Uncles annuity was paid to my fathers estate, the insurance company paid Federal and State income on the taxable Income amount (my father was 100% disabled did not pay income tax, the minimum amount taken was 10% for both Federal and State Tax). Is there any addiotnal taxes due on this money prior to each child receiving a small portion of funds.
June 18th, 2010 at 11:01 am
Thank you for sharing this information on annuities. It’s also a confusing subject for me, and this blog is helping me to better understand it.
July 10th, 2010 at 11:23 pm
While inheritance is not taxed to the recipient, any interest or dividend on the money should be taxed. Your annuity company should provide all the tax details. t