Many people turn to annuities to take advantage of their tax benefits, as well as their unique ability to help hedge against the financial danger of outliving your money. Yet when an annuity owner passes away without ever having annuitized his or her policy to pay regular income, the person named as beneficiary has some key decisions to make.

In particular, unlike many other assets that one can inherit, annuities typically come with a built-in tax burden for an heir. Let's look more closely at how much you have to pay in taxes on an inherited annuity.

Annuities: Different rules apply
For most types of property, income taxes on an inheritance are quite simple. The typical case involves assets that are eligible for what's known as a step-up in tax basis to the date-of-death value of the inherited property, which effectively erases any built-in capital gains tax liability, and gives the heir a clean slate against which to measure future profits or losses.

Tax laws treat investments that are eligible for tax-favored status -- such as IRAs and annuities -- differently. For annuities, the key to taxation is how much the deceased person paid to purchase the annuity contract, and how much money the deceased person received from the annuity before death.

IRS Publication 575 says that, in general, those inheriting annuities pay taxes the same way that the original annuity owner would. In turn, taxation of annuity distributions depends on whether they started before or after the required starting date for payouts.

If you elect periodic distributions, then the portion of each payment that comes from accumulated earnings is taxable, while the portion that comes from the original premium payment is not. If you elect nonperiodic distributions, however, the IRS typically treats distributions as taxable earnings until they're used up, after which further payouts are treated as return of the original premium payment, and therefore not taxable.

Often, those inheriting an annuity choose a lump-sum payout. In that case, the taxation is much simpler. You'll pay tax on everything above the cost that the original annuity owner paid. The amount that represents the original premium payment is treated as tax basis, and therefore excluded from taxable income.

There is a special exception for those who are entitled to receive guaranteed payments under an annuity contract. In this case, you're allowed to treat the first money received as tax-free return of capital up to the amount that the deceased person paid for the annuity. Above that amount, payouts are taxable. This reverses the usual rule, and can be a big benefit for those inheriting an annuity.

Inheriting an annuity can be more complicated than receiving other property as an heir. By being aware of special rules, though, you can choose the least-taxed options available in taking the money that's been left to you.

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