Annuities offer the owner a way to save money with tax-deferred growth until they remove it, or a tax-preferred treatment if they select annuitization. It also allows the owner to name a beneficiary in the event of their death. If the owner/annuitant dies, the beneficiary can take annuity payments for life, withdraw the funds over a five-year period or take an immediate lump sum benefit, all of which trigger taxation and potential inheritance tax.
There are two types of potential taxes on an inherited annuity. The first is income tax on the growth of the annuity, and the second is inheritance tax. There isn't necessarily any inheritance tax on every annuity, but there will always be an income tax on the proceeds.
Even though in 2010 there was no federal estate tax and in 2011 and 2012 the federal estate tax exemption was $5 million, some states have a state inheritance (estate) tax that requires a payment from either the estate or the beneficiary of the asset. An annuity is taxable in this case, depending on the amount of the estate, the amount of the annuity, the relationship of the beneficiary and/or the state exemption
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Just like the owner of the annuity, the beneficiary pays taxes on the funds received when the owner dies. The taxes due are on only the growth, and even if the recipient is under 59 1/2, there is no 10 percent penalty. If the beneficiary takes payments over their lifetime, the insurance company divides the taxable amount by the beneficiary's life expectancy and it's subject to tax in the year of receipt. If the annuity was a traditional IRA or other qualified contract such as a SIMPLE IRA, the entire amount is subject to tax.
Unlike a spouse, non-spouses, such as sons or daughters, can't simply take ownership of a non-qualified (non-IRA) annuity, but must take the funds within 5 years even if it's a beneficiary annuity. If they want to annuitize, they must do it within 60 days. Some fixed annuities stop paying interest at the death of the owner, so submitting the beneficiary form as soon as possible is important. Variable annuities pay the amount the account was worth on the day the insurance company cashed out the account with no stepped up basis from the date of death.
Basis is the amount of money the owner put into the annuity. The balance is growth and taxable. Be aware that when 1035 tax-free transfers from one annuity to another first became popular, many insurance companies failed to record the amount transferred and instead, show no basis or only a partial basis from money put into an annuity after transfer. Make certain that you check on the potential of 1035 transferred funds if you notice a newer annuity has a high taxable amount in proportion to the amount you received.
While most annuities have no fees when the proceeds go to the beneficiary, a few companies do. These fees lower the profit made on the annuity and reduce the taxable amount.