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.

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