While receiving an inheritance can come as a positive surprise, there may be worries about the tax consequences. In many cases, when investments pass to heirs, the securities come with a significant tax advantage and little or no taxes owed. However, in the case of a non-qualified annuity investment, the heirs could be on the hook for some taxes.
Qualified vs. Non-Qualified Investments
In tax terms, qualified means the investments are held in an account designated by law as a tax-advantaged retirement savings account. Two commonly owned examples of qualified money would be individual retirement accounts and employer-sponsored 401(k) accounts. Both contributions and earnings in a qualified account are sheltered from income taxes. Stocks, bonds and other investment instruments not owned in a designated qualified account would be non-qualified investments. The original owner of these investments paid taxes on dividends or interest as they were earned, and on any capital gains resulting from selling investments for a profit.
Step-Up in Basis of Willed Investments
The heir to non-qualified investments receives the investments with a potentially significant tax benefit. Inherited investments pass to the heirs with a cost basis set at the value of the investments on the date of the original owner's death. This step-up in basis means the heirs will pay no taxes on the gains generated by increases in the investment value before the owner died. For example, say your uncle paid $1,000 for some stock that was worth $50,000 when he died and left the shares to you. If you sell the fund shares, your cost basis would be the $50,000 and you would pay taxes on the gain between the sales value and $50,000. The $49,000 gain your uncle earned on the fund shares will never be taxed.
Non-Qualified Annuities Are Different
Annuities are tax-advantaged savings investments that can be purchased with either qualified money -- such as with IRA funds -- or non-qualified money. In either case, the earnings generated by the annuity grow tax-deferred until withdrawals are taken from the annuity. A non-qualified annuity lets the buyer shelter interest or investment gains from taxes to let the annuity value grow and increase without paying any taxes on the growth.
Inheriting an Annuity
In a non-qualified annuity, the original investment amount passes to the heirs without any taxes due, but taxes must eventually be paid on the gains in the contract. A spouse who inherits the non-qualified annuity will have the option to continue the annuity and delay the payment of taxes. Any non-spouse heirs will be required to receive the value of the annuity and pay taxes on the tax-deferred gains. Annuities are transferred to the heirs through beneficiary designations and typically are not handled by the estate.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.