Is Annuity Inheritance Taxable by the Fed & Michigan?

An annuity is a type of financial insurance that provides a steady stream of payments for the owner on a schedule the owner chooses. When the annuity owner dies, then the annuity becomes part of the deceased's estate. If you've inherited an annuity, the income you receive from it must be reported on your income taxes, but how much you're taxed depends upon how much you receive.

Federal Taxes on Annuities

Annuities offer owners the opportunity to grow investments on a tax-deferred basis with no contribution limit. When the owner begins payments, the income he receives is taxed by the Internal Revenue Service (IRS) at his current tax rate. When you inherit an annuity, the payments you receive are taxed the same way; as of the time of publication, the top federal tax bracket is ​37 percent​.

You can elect to take a lump sum payout or take distributions. Keep in mind that you'll get to share in the estate tax deduction if the decedent's estate incurred estate tax. You can deduct the estate tax in the years that you receive payments from the annuity.

Michigan Taxes on Annuities

Although Michigan does not impose a separate inheritance or estate tax on heirs, you may have to pay state taxes on your annuity income. How much – or if – you'll pay depends upon where the annuity came from and how much it's worth.

According to DGKT Accountants, here are the three tiers for the most recent (2020) tax changes to retirement funds in the State of Michigan:

  • Individuals that have a birthday dating back before 1946 will have no change in tax breaks as before so their pensions won’t be taxed at all and private pensions, 401(k)s, and IRAs will only be taxed on the amount over ​$47,309​ for individuals and ​$94,618​ for joint filers.
  • If you were born between 1946 and 1952, all retirement income will be taxed, both private and public pensions. A small exclusion is made for individuals filing with ​$20,000​ or joint filing ​$40,000​.
  • Anyone born after 1952 has to pay taxes on all retirement income until the age of 67. When they are 67, they’re eligible for an exclusion for individuals filing at ​$20,000​ and joint filers at ​$40,000​. They may also opt to deduct ​100 percent​ of SS income as well as railroad pensions and military pensions.

When filing jointly, the age of the older individual is what these numbers are based off of.

How Gains Are Reported

After you receive your distribution, you'll get a Form 1099-INT in the mail from the annuity's custodian. Whatever the annuity earned in interest – and you received as income – from the date of death is taxable to you. If the policy gained value, that increase is reported on Form 1099-R. If you're unsure how to report the gain, contact a tax adviser who understands Michigan's tax laws as well as federal tax laws.

Avoiding the Trap

Many life insurance policies offer owners the chance to purchase an annuity with their cash balances. Although annuities are popular retirement planning options because of the guaranteed income option, it may be wiser to take a policy loan with your life insurance cash balance instead of purchasing an annuity.

As of the time of publication, life insurance loan proceeds aren't taxable, while annuity proceeds are. Although annuity heirs are powerless to make this change after the fact, it's an important cautionary tale.