The last thing anyone wants to hear is that they owe taxes on an annuity they inherited. Take heart, it may not be as bad as you think. In this blog we’ll talk about how the taxes and distribution rules for an inherited annuity work, and what to do if you are faced by this situation.
Before we get into the blog, we are financial planners in Morristown, New Jersey. Although nothing in this article may be interpreted as tax or legal advice (ask your CPA or legal advisor for such guidance), we’ve written other blogs on financial planning, investments, and retirement that may be useful to you:
Is the life insurance provided by my employer enough?
Our easy, clear take on the question of if Social Security increases with inflation
End of year financial planning
What to do When Your Social Security Benefits Are Reduced
I’m invested in a 2030 target date fund – help!
And now let’s get into it!
Okay, so you inherited an annuity…
You mourned the passing of a dear relative, and all of a sudden you get this notice in the mail that you are the new owner of the person’s annuity. They named you the beneficiary.
“Wow!” you say.
Super appreciative, you delve into the details, only to find that despite receiving the benefit of owning this asset, there’s just this one little thing…
You may owe tax on the annuity you inherited.
This can put quite a damper on the euphoria. Fortunately, there is a systematic way to approach the issue! Let’s start with some basic inherited annuity distribution rules.
The questions you should ask when you inherit an annuity
The first thing you have to know is this: is the annuity qualified or non-qualified. Most people don’t know. On the annuity statement it will say if it is non-qualified or qualified.
Once you know if the annuity is qualified or non-qualified, you can start to think about how the taxes on your inherited annuity are likely to work.
Non-qualified annuity
This means that the annuity is contained in a non-retirement account, such as a taxable brokerage account. The question you should ask yourself is if the annuity has a gain.
The gain upon distribution for a non-qualified annuity is going to be taxed as ordinary income.
Two important things to note:
- It does not get taxed as a capital gain – it is taxed as ordinary income.
- The cost basis does not get stepped up.
So that’s where inheriting an annuity can be a potential income tax trap.
How can you handle this situation? Consider the non-qualified stretch which can spread out distributions over the beneficiary’s lifetime.
Many times, people elect to take the distributions over their lifetime so that they don’t get a huge one-time tax bill. Please bear in mind that we are not CPAs and nothing we write here may be considered tax advice specific to any one individual.
If there is no gain on the annuity, you can take the distribution without tax consequences.
Qualified annuity
If the annuity is held within a retirement account, it is a qualified annuity. This is usually when the asset is held in a Roth or Regular IRA.
Should that be the case, whatever happens inside the IRA structure makes no difference to your tax bill. The only thing that matters is when you take the annuity out of the account. If you roll it over to another IRA, that is not a taxable event. Essentially, keep in mind the inherited IRA distribution rules because these also apply to qualified annuities.
Whatever comes out of the IRA is taxed as ordinary income, if held in a Regular IRA. If held in a Roth IRA, the distribution is not taxable.
However, it can get a bit complicated in a few aspects.
- The income benefit that mom or dad had, or whoever was the original owner of the annuity, may be gone. Or there may be a spousal benefit – you have to check on it. If you are a child inheriting the annuity, you likely won’t receive income distributions as the original owner did. There are exceptions, but this is the typical situation in our experience.
- If the annuity has a death benefit rider that pays out more than the contract value was, factor that in when thinking about the gain and remember that the gain is taxed as ordinary income.
It’s important to understand how these assets are distributed from an IRA. As we said before, we are financial advisors not CPAs and what we are saying can’t be interpreted as suggestions specific to you about how your inherited annuity is going to be taxed. If you seek guidance specific to your situation please consult with your tax advisor.
Grappling with inherited annuity tax questions?
Yes, we know, this kind of stuff is about as fun to tackle as a trip to the dentist.
Luckily, you are not alone.
We are financial advisors in Morristown, NJ serving the local community and beyond. If you have questions about how to manage an annuity or ay other asset, your portfolio, your financial plan, retiring in New Jersey, moving there, affording to live there, or (like us) are just plain old Bruce Springsteen fans, reach out and send us a message.
Sources
Durante, Alex. (18 October, 2022). 2023 Tax Brackets. Tax Foundation. https://taxfoundation.org/data/all/federal/2023-tax-brackets/