Tax Rules for an Inherited Non-Qualified Annuity

Heirs of these contracts need to be aware of their key attributes.

Dec 19, 2015 at 11:51PM

Inheriting assets typically comes with tax implications, and some assets have more complex tax ramifications than others. Non-qualified annuities have a host of complicated tax aspects, and when you add an inheritance into the mix, you have to be careful to understand all the rules that apply. Let's look more closely at the key tax rules on inheriting a non-qualified annuity.

Heirs: spouse vs. others
Taxation of inherited annuities is different for spouses and non-spouses. The surviving spouse often has the right to continue the annuity contract, in which case, the death of the original annuity holder has no immediate tax consequences.

For others, the tax impact varies depending on the payout choice that the heir makes. If the heir takes an immediate lump sum, then the portion of the annuity that represents the growth in value from the deceased person's original premium payments will be taxed as ordinary income to the heir. The heir also has the choice of spreading out payments over a longer period. While any appreciation distributed to the heir will be treated as taxable income, the smaller payments allow the heir to spread out tax liability over a longer period.

Note that in no case does the heir get a stepped-up basis in the annuity asset. Because of the tax-deferred nature of annuities, tax law treats them the same way they do IRAs and 401(k)s, thereby assuring that the amounts won't escape income taxation.

Can an heir switch annuities?
One issue that often comes up involves an heir of an annuity from a high-cost insurance provider. For an annuity that you purchased, you can do a tax-free exchange under Section 1035 of the Internal Revenue Code to a different annuity provider without incurring income tax.

For heirs, however, the law governing 1035 exchanges hasn't been as clear. A 2013 private-letter ruling from the IRS allowed an inherited IRA beneficiary to do a tax-free exchange without any tax consequences, but some insurance providers aren't willing to rely on that guidance, as it technically applies only to the taxpayer who requested the ruling. If you're fortunate enough to have an insurance provider that will be flexible with you, considering a 1035 exchange, because a less-expensive annuity can be a smart move.

Taxation of inherited annuities gets complicated in a hurry, but the general rule to remember is that, because the tax-deferred income escaped taxation during the original owner's lifetime, the heir will need to pay tax on that income sooner or later. By using various strategies, an heir can delay the day of reckoning considerably; but eventually, the IRS will get what's coming to it.

The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at knowledgecenter@fool.com. Thanks -- and Fool on!

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers