Annuities are renowned for the safety and security they can provide for savers who need to accumulate funds for retirement as well as for retirees who rely upon them for a guaranteed stream of income. And for both of those purposes, the tax implications are fairly straightforward: Tax deferral during accumulation and ordinary income taxes due on earnings when withdrawn or taken as income. Annuities that are transferred to heirs as part of an inheritance may create a more complex set of tax consequences, so it would be important to fully understand inheritance options in order to minimize problems and taxes.

One of the distinguishing features of annuities is their guaranteed death benefit which, like a life insurance policy ensures that beneficiaries will receive, at the very least, the principal investment made by the annuity owner. Annuities held over a period of time will have accumulated earnings which are also payable as part of the death benefit proceeds. Because earnings are allowed to accumulate tax deferred while the annuity owner is alive, they will become taxable as ordinary income when they are paid to the beneficiaries. The beneficiaries do have several options for taking receipt of the proceeds which, depending on their situation, could impact the level of taxation at any one time.

The Annuity Taxation Shock

What few annuity owners (and their beneficiaries) realize is that annuities, unlike most other investments, do not receive a stepped up basis when they are passed into an estate. For other investments, a step up in basis occurs when the assets are passed through the estate. If the investment has a gain in value, the basis of the investment is increased to equal the original principal plus the gain which, in effect, means that there would be no tax consequence on the gain.

This can prove to be a shock to annuity beneficiaries when they realize that the full amount of earnings that accumulated over the years is suddenly includable in their own taxable income. Annuity owners should prepare their beneficiaries for that fact, at least to the extent that they can help them plan for them or understand their options.

Five Year Withdrawal Limit

When annuity proceeds are made available to the beneficiaries, they can take up to five years to withdraw the funds. This is important because only the portions of the proceeds withdrawn are subject to income tax and the funds remaining in the balance continue to accumulate tax deferred. Generally, funds can be withdrawn in any increment so long as they are completely distributed within the five years. It is possible to simply wait a full five years before taking any withdrawals, thereby maximizing the tax deferral on the earnings.

When annuity proceeds are withdrawn, it is important for the recipient to plan accordingly for the additional taxes that will be due. Based on their individual tax brackets, beneficiaries should plan on setting aside an amount equal to their tax bracket percent into a separate account, or, better yet, simply send it to the IRS. So, as an example, if $10,000 is taken from the proceeds and the beneficiary’s tax bracket is 25%, $2,500 should be set aside to pay the taxes. An income tax analysis should be done to determine whether the withdrawal will actually bump the tax bracket to the next level, which would mean that the proceeds would incur a higher tax.

Income Option

Alternatively, the annuity could be converted into a stream of income for a specified number of years of for the life of the beneficiary. When this happens, also referred to as annuitization, the beneficiary will receive the proceeds as period payments. The payments will consist of a portion of the deceased annuity owner’s principal, which is not taxable, and interest earnings which are taxed as they are received.

Taxation of Annuity Income after Annuitization

If an annuity owner dies after the annuity had been annuitized and payments had been received, the income could continue to a spouse who was named as a joint owner of the annuity. The payments would be received as established and the spouse would continue to pay taxes on the interest portion. If additional beneficiaries were named, and a refund option was selected, the beneficiaries would incur taxes on the portion of the refund that is earned interest.

Summary

The taxation of annuities is fairly straightforward for owners who are using them as accumulation vehicles or as a guaranteed income source. At the death of an annuity owner, the taxation of annuities can be somewhat perplexing for survivors who are prepared for their tax treatment. The guaranteed death benefit in annuities can be great source of comfort for annuity owners, but if they want to maximize their comfort as well as they value of their legacy, it is best if they prepare their family members ahead of time.