You can roll over an inherited qualified annuity. This type of annuity resides in an individual retirement account or employer plan. A nonspouse beneficiary has limited options regarding how to roll over the annuity and when taxes are due. Inherited qualified annuities are taxable unless they reside in a Roth account. You can also roll over a nonqualified inherited annuity through a Section 1035 exchange.
Factors to Consider
The first step in determining your taxes is understanding exactly what you are inheriting. If your parent died before she began receiving annuity payments, you will inherit the cash value of the annuity. You may also receive a death benefit in excess of the cash value. If your parent was receiving annuity payments, the policy generally no longer has a cash value. You may receive payments if your parent did not fully collect a guaranteed number or amount of payments. If your parent’s annuity had survivor benefits, you’ll receive payments for a set period or for the rest of your life.
Your tax bill depends on the annuity’s cost basis, which is the amount of nondeductible premiums your parent paid into the contract. Qualified annuities normally have no cost basis because all the contributions were made with pre-tax money. Roth annuities are the exception -- the cost basis is equal to the amount contributed. You will include in your taxable income the annuity payments in excess of the cost basis. If you receive guaranteed payments, you don’t have to pay taxes until all of the cost basis is paid out. Otherwise, your taxes are based on the percentage of each payment that is not part of the cost basis. For qualified non-Roth annuities, this is normally 100 percent.
Rolling It Over
You can roll over any qualified annuity distribution into an “inherited IRA,” which is a special account registered in the deceased’s name for your benefit. You can’t make additional contributions to an inherited IRA, and you can’t roll it over to another account. You only pay taxes on the money when you take it out of the IRA. If you inherit a survivor annuity, you must receive payments at least as frequently as did your parent. If you receive a lump-sum distribution, you can use the Internal Revenue Service's required distribution rules to stretch out your withdrawals, which has the effect of delaying your tax payments.
You normally have five years to distribute the money in an inherited IRA. However, you may instead choose to take minimum withdrawals over a period equal to the expected lifetime of the oldest beneficiary or the life expectancy of your parent as of her final age. The taxable portions of your distribution are ordinary income, taxed at your marginal rate -- the tax on the “last dollar” of your annual income. You can convert a traditional qualified annuity into a Roth IRA, but you’ll have to pay current-year taxes on the converted amount. Once converted, distributions from a Roth annuity are tax-free.
If you inherit a nonqualified survivor annuity, you have the right to make a Section 1035 exchange, in which you exchange the existing annuity contract for a different one in this tax-free transaction. The taxes on the nonqualified annuity pertain only to the payments in excess of the original cost basis. Include in your annual income the amounts that aren't cost basis.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.