Annuities allow owners to grow their savings tax-free until they distribute the money through annuitization or withdrawal. If you inherit an annuity from your father, you'll pay taxes on the portion of the account that represents the earnings on the amount paid in. If the deceased paid $100,000 into the annuity and it grows to $150,000, you pay ordinary income tax on the $50,000 increase as it is withdrawn.
Annuities are usually funded with after-tax dollars. Immediate annuities pay an income stream right away, while deferred annuities have a pay-in and a payout, or annuitization, period. The money paid in either as a lump sum or over time is the original amount invested and is not taxed when distributions are made. The amount above that -- which can be gains from investment performance or a guaranteed rate of return -- has not been taxed. It gets taxed when the owner or beneficiary takes distributions.
Figuring Out Gains
The insurance company holding the annuity can give you an exact breakdown of the original investment and any gains. If you choose to take a one-time payout of the proceeds, you'll pay ordinary income taxes on the gains in the year of the lump-sum distribution. A lump-sum payout typically costs you the most in taxes, because it can bump you into a much higher tax bracket depending on the sum of the distribution.
Choosing Periodic Payments
You can also take the distributions over a period of five years. If you do this, taxation is based on the last in, first out, or LIFO, method. This means the initial distributions will represent earnings and will get fully taxed, but eventually you'll get to the distributions that represent the original investment. These are considered return of principal and will not get taxed at all.
Deciding to Annuitize
You can also choose to annuitize based on your life expectancy. This will spread the income payments over a longer period of time. The lower payments over a longer period of time should result in the lowest taxes. The amount of the account that is earnings, your current income tax situation and upcoming tax changes can have a significant impact on your decision. Therefore, it's a good idea to consult a professional tax adviser before finalizing your selection.
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