Do I Have to Pay Taxes on an Inherited Annuity of My Deceased Father?

If your dad left you an annuity, you have several options when it comes to distribution. When inheriting an annuity from a parent, you will have to pay taxes on payments as ordinary income. Only a spouse can inherit an annuity and benefit from the options the late spouse enjoyed.

TL;DR (Too Long; Didn't Read)

If your dad left you an annuity, expect to pay taxes at your ordinary income tax rate on the interest, but not the premium.

How Annuities Work

Perhaps your father left you additional assets that are somewhat easier to grasp than annuities, such as bank accounts or real estate. An annuity is generally a retirement asset created by the owner in conjunction with an insurance company. This contract promises to pay the owner, known as the annuitant, a specific sum of money on a certain timetable for a predetermined period. The annuitant funds the annuity, and in return is guaranteed this particular stream of income. The annuitant can name a beneficiary to receive the annuity after his death.

Annuities fall into two distinct classes when it comes to income distribution. With an immediate annuity, the owner starts receiving income right away. That will limit your choice when it comes to how you want to receive your distribution. With a deferred annuity, the taxes on any gains are deferred until the owner begins taking withdrawals. Fixed income annuities return a predetermined rate, while the return with variable rate annuities may change. The former are generally invested in government bonds and other guaranteed securities, while the latter invests in riskier assets but may pay a higher rate.

Tax Liability on Inherited Annuity

Your tax liability depends to some extent on your choice of distribution or if your father was already taking annuity payments at the time of his death. In the latter case, you must take the payments in the same manner in which your father was taking them. These are usually fixed payments in which you pay taxes on the interest based on your income tax rate but not on the premium part of the payments.

Lump Sum Payment

If you opt for a lump sum payment, you receive the entire amount of the annuity at one time. Although you will not owe taxes on the principal or the amount your father paid into the annuity, you will owe taxes on the interest the premium has earned. For example, if your father put $250,000 into the annuity, you will not owe taxes on that amount when receiving the lump sum payment, but if the annuity has earned $50,000 in interest, you will owe taxes on the interest based on your ordinary tax rate.

Your Lifetime Annuity

Another option is annuitizing the policy over your lifetime, which results in regular, fixed payments over the years and thus spreads out the tax burden. This is also known as a non-qualified stretch annuity, as the minimum payments are now “stretched” during your lifetime. Of course, no one knows exactly how long they will live, but life insurance actuaries determine individual life expectancy based on a complicated formula involving the deaths of those younger than you. Once you reach a certain age, you are less likely to die young, so your life expectancy has actually increased.

Taxes are not owed on the payment that is part of the premium but only on the interest. You must decide to annuitize the policy over your lifetime within 60 days of inheritance. The insurance company or your attorney can advise you regarding the details of your inherited annuity.

Five-Year Deferral Inherited Annuity

Under the five-year rule, as the annuity beneficiary, you must receive the entire distribution within five years of your father’s date of death. You can choose to take out smaller amounts during the prior five years, but by the fifth anniversary of the death, the full amount of the annuity requires disbursement. Some beneficiaries may decide to wait and take out the entire amount in the fifth year.

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