Taxability of Annuities for Beneficiaries

Annuity distributions consist of a return of the principal invested in the contract, and earnings on that invested amount. Distributions from an annuity -- such as to a beneficiary -- will be regular taxable income on the amount that is classified as earnings. The tax rules are set up so that when the owner dies, the heirs to the annuity must start drawing out the money and paying taxes. Beneficiaries have some flexibility concerning withdrawals if the annuity was still in the accumulation phase -- indicated by a lump sum available for heirs to inherit. If the annuity has been converted to an income stream -- "annuitized," in insurance jargon -- the selected annuity payout determines how the money will come to the beneficiaries.

A spouse as beneficiary of an annuity has the most flexibility regarding paying taxes on the earnings. She can treat the annuity as her own and let the account continue to grow tax-deferred for as long as she wants or until the annuity passes to the next beneficiaries in line. If the spouse elects to take withdrawals or annuitize the account, earnings will be taxable as the withdrawals or annuity payments are made.

If you are a beneficiary who is not a spouse, you must select some form of withdrawal option to pull the money out of the inherited contract and pay taxes. Taking the full amount right away will result in the immediate payment of taxes on the earnings, leaving the balance to use as you wish. You can roll the annuity value into a deferred annuity in your name, and then you must take out the full value within five years after the original owner's death. This option lets you spread the tax bill over a period of several years, if you wish, or wait until the end of the fifth year and pay taxes then. You can also convert the sum to annuity payments -- annuitizing the contract -- and pay taxes based on the payment schedule you select.

An annuity has both a named owner and an annuitant -- the person who will receive payments if the contract is annuitized. Owner and annuitant can be, and often are, the same person. If the annuitant is different than the owner, the death of the annuitant triggers the passing of the account to the beneficiaries. Also, if the annuitant and owner are different, beneficiaries younger than 59 1/2 are subject to an extra 10-percent tax penalty on paid-out earnings. If the annuity passes to the beneficiaries due to the death of an owner who is also named annuitant, the 10-percent tax penalty does not apply.