You may have heard that when you inherit assets the tax basis changes to the date of death. That is, if the deceased bought stock on Jan. 2, 1995, and died on Feb. 5, 2017. When you, as the heir, sell the stock, you owe taxes only on any increase in value from the date of death rather than from the day the deceased bought the stock.
Many people mistakenly think this applies to all inherited assets. Annuities are among the inherited assets for which the tax basis remains the same as it was for the deceased. In other words, you would owe taxes on any portion on which the deceased had not paid taxes.
Inherited annuities are taxable, and the amount of tax you pay will be the same as the deceased person was paying.
Types of Annuities
Generally, there are two types of annuities you might inherit. A tax-sheltered annuity, officially known as a 403(b) plan, is a retirement plan offered by public employers, such as public school districts. It works much like a traditional individual retirement account in that the employee makes tax-deductible contributions and the investment grows tax-deferred, but distributions are taxed as ordinary income. Individuals can also purchase their own non-qualified annuities from insurers or financial institutions.
There are many different types of these annuities, but the basic concept is the same: The individual buys the annuity with after-tax dollars in the form of a lump sum. The institution invests the lump sum with the idea of providing monthly income to the purchaser at a later date. The investment income is not taxed until it is distributed.
Inheriting a TSA
Most likely the entire amount of any tax-sheltered annuity (TSA) you inherit will be taxable. If you're not the spouse of the deceased, you basically have two options for taking distributions. You can take the entire value of the annuity as a lump sum, or set up an inherited IRA to receive the money. You won't be able to contribute to this IRA, but you will be able to spread out the distribution by beginning required minimum distributions based on IRS tables by the end of the year following the year of death.
You'll pay taxes on each distribution, but, generally, you can spread it over your lifetime. A spouse beneficiary has the option to roll a TSA distribution into any qualified plan and treat it as her own. This would include an employer's 401(k) if the plan accepts rollovers.
If the deceased purchased the annuity on their own, the original investment was already taxed, but you'll still owe taxes on the portion attributable to investment income. As with any annuity, you have the option to take a lump-sum distribution and pay all the taxes in one year. You can also spread distributions of the entire amount over five years. In this case, all your distributions will be considered fully taxable until you've removed all the investment income. After that, distributions will come from the original investment and not be taxed.
You have to monitor this carefully, because if you end up waiting until year five to take all or most of your distribution, you'll still get hit with a hefty tax bill. Finally, you can choose to spread distributions over your expected lifetime. In this case a portion of each payment would be taxable. You have 60 days to make this decision. Spouses may be able to assume the annuity and make it their own.
If the holder of a non-qualified annuity dies after the annuity starting date, you must take distributions at least at the same rate, which generally means you can take the five-year payout or continue with the payout option the deceased chose.When making decisions about inherited annuity options, particularly a non-qualified annuity, you may want to discuss your options with a tax adviser or financial adviser. Among tax issues to be considered is a comparison of the tax benefits of spreading out your annuity payments against the investment returns you could receive by investing that money elsewhere.