Inheriting an annuity from a deceased loved one can provide a boost to your finances, but such an inheritance can also make your tax situation a bit more complicated. If you have inherited an annuity or expect to inherit in the future, investigate your options. The IRS is standing by waiting to take its cut of the action, and making the wrong moves now could leave you with a big tax bill down the road.
Withdraw all the Money from the Annuity Within Five Years
One option when dealing with an inherited annuity is to take out all the money within a five-year period. With this option, the individual who inherits the annuity can choose when and how to take the money out, providing that all the money has been withdrawn within five years. The individual could simply withdraw all the money from the annuity right away, take out portions every month, every year, etc. or wait until the full five years have passed and withdraw all the money at that time. No matter which strategy is chosen, any money remaining in the annuity will continue to grow on a tax-deferred basis, while funds withdrawn from the inherited annuity will be subject to income tax.
Creating a Stream of Income
The other option is to use the annuity to create a stream of income – for either a set number of years or for the lifetime of the individual. When choosing this option, part of each payment from the annuity will be tax-free. The tax-free amount is based on the amount originally invested versus the value of the annuity and its accumulated earnings. By law, the insurance company that holds the annuity must provide the new owner with a report showing how much of the withdrawn funds are taxable.
The person inheriting the annuity is responsible for paying income taxes on the difference between the amount the deceased individual put into the annuity and the total payments the recipient receives. Due to the nature of annuity payments, the actual timing of the associated tax bill can vary, but the rules set up by the IRS dictate that the accumulated gains from an inherited annuity are subject to tax. The calculations will be different depending on whether the five-year option or the income stream option is chosen, but it is important to keep in mind that the gains on the annuity are subject to taxation.
For individuals who do not need the money right away, it may be more tax-efficient to use the five-year option but wait until the end of that five-year period to cash in the annuity. This strategy allows the money in the annuity to continue to grow and could result in a more substantial nest egg when it is time to cash out. The person inheriting the annuity can put some money aside each year to cover the taxes that will be due.
Those who need the money may be better off cashing the annuity in right away and using a portion of the proceeds to settle up with Uncle Sam. This strategy can still provide plenty of extra income to pay bills, pay off debt or even take a much-deserved vacation.