First, know that there are 2 types on annuities from a tax perspective: Qualified, or non-qualified.

A qualified annuity means that the money was saved in a IRA or 401(k), and there were no taxes paid upfront. When you take money out of an inherited qualified annuity, the full amount withdrawn will be taxed at your ordinary income tax rate, which can be quite high.

Your options depend on your relationship to the person that passed away and inherited the annuity from. You will have a set time frame that you must withdrawal the assets from the annuity after the initial owners death.
If you are a surviving spouse, or a minor child, you have more flexibility here. But if not, you must follow IRS rules on the withdrawal. Because of the tax consequences of withdrawals from qualified annuities, this means you need to carefully plan on the best way to withdrawal from the account with the lowest amount in taxes paid.

Non-qualified annuities were funded with savings that already had taxes paid. You will still owe taxes on the growth of the annuity however.

It is also important to know that annuities can be exchanged as well. This is known as a 1035 exchange and allows you to move the money from a qualified or non-qualified annuity into a different annuity.
This can be a good option if the annuity you inherited has high fees, or is just not right for you.

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Inherited Annuities – Taxes and Rules

Annuities are popular financial instruments that individuals often use to secure a steady stream of income during retirement. They are often passed down to beneficiaries upon the death of the annuity holder, resulting in inherited annuities. However, it’s important to understand the tax implications and rules surrounding these inherited annuities.

Taxes on Inherited Annuities:

When it comes to inherited annuities, taxes can be a complex matter. The tax treatment depends on various factors, such as the type of annuity, the age of the deceased annuity holder, and the relationship between the deceased and the beneficiary.

If the annuity was purchased with pre-tax dollars, such as a traditional individual retirement account (IRA) annuity, the beneficiary will have to pay income tax on the value of the annuity distributions. These distributions are taxed at the beneficiary’s ordinary income tax rate.

On the other hand, if the annuity was purchased with after-tax dollars, such as a Roth IRA annuity, the beneficiary generally won’t owe income tax on the distributions. This can provide a significant tax advantage, as the inherited annuity’s growth will be tax-free.

In addition to income tax, there might also be potential estate taxes involved. If the total value of the deceased annuity holder’s estate is above the estate tax exemption threshold, estate taxes may apply. It’s important to consult with a tax advisor or estate planning attorney to determine any potential tax liabilities.

Rules for Inherited Annuities:

Inherited annuities are subject to certain rules and regulations set by the Internal Revenue Service (IRS). It’s crucial to understand and comply with these rules to avoid any penalties or unintended tax consequences.

One critical rule is the required minimum distribution (RMD) rule. The beneficiary of an inherited annuity must start taking annual distributions, based on their life expectancy, by December 31st of the year following the annuity holder’s death. Failure to meet the RMD requirements can result in penalties.

The life expectancy factor used to calculate the RMD can be determined using the IRS Single Life Expectancy Table. The divisor for the first year is the beneficiary’s life expectancy, and it gets reduced by one each subsequent year. It’s essential to consult with a financial advisor to accurately calculate the RMD and ensure compliance.

Another important rule to consider is the five-year rule. If the annuity holder passed away before reaching the required beginning date for distributions, which is usually 72 years old, the beneficiary may have to distribute the entire inherited annuity within five years. However, certain exceptions, such as if the beneficiary is the spouse, disabled, or chronically ill, may allow for a longer payout period.

Final Thoughts:

Inherited annuities can provide a valuable source of income for beneficiaries. However, understanding the tax implications and rules associated with these annuities is crucial to avoid unexpected tax liabilities and penalties.

Consulting with a tax advisor, estate planning attorney, or financial planner is highly recommended to ensure proper compliance and maximize the tax advantages. They can provide personalized guidance based on the specific circumstances and help make informed decisions regarding inherited annuities.