Tax Rules for an Inherited Non-Qualified Annuity

Once set up, an annuity is designed to pay someone money, often in monthly payments, for the rest of their life. Insurance companies typically offer annuity products, and investors can purchase a rider for the annuity plan to add a death benefit. This ensures that, if the annuitant, or person receiving the annuity payments, dies before the annuity term ends, his remaining payments can go to a beneficiary of his choosing. Like some other investment vehicles used to fund retirement, annuities come in two varieties, qualified and non-qualified.

A non-qualified annuity means that you'll receive no tax deduction up front for your contributions to the annuity, but you also won't pay taxes when withdrawing your original funds. These plans are typically funded with after-tax dollars, so you don't need to pay the tax man twice. You will, however, need to pay tax on any interest earned on the original funds invested in the annuity. Non-qualified annuities also don't have any required minimum distribution.

Non-qualified annuities have a similar tax treatment to some other types of retirement-focused investments. The money paid into this type of annuity grows on a tax-deferred basis, and once the annuity owner starts receiving payments, she'll pay her ordinary income tax rate on the money. When someone inherits the annuity from the original owner, a few different tax implications arise. If the surviving spouse is the beneficiary, the contract simply transfers as if the spouse were the original owner, with the same tax treatment as the owner would have had.

For a non-spouse beneficiary, a few different inherited non-qualified annuity options exist for payout, which will determine how the money gets taxed. If the beneficiary decides to take all of the annuity money in a lump sum payment, she'll need to pay taxes on the interest portion of the funds. The original contributions, i.e., the principle, won't be subject to any taxes. If the heir decides instead to continue getting the periodic annuity payments, she'll pay tax on each payment as it's distributed, spreading out the tax liability potentially over years.

Sometimes the person inheriting an annuity chooses to sell it and use the proceeds to take care of existing debt, college tuition for the kids or other expenses. A sale can happen in a few different ways. The beneficiary can sell the entire contract and take a lump-sum payment one time, or he can choose to sell his payments for a portion of the annuity's payment schedule.

For example, if a person had 15 years of annuity payments remaining, he could sell seven of those years' payments and receive a lump sum. In the eighth year, he'll start to receive the annuity payments again, through the end of the contract. He could also sell a part of each payment, receiving a one-time lump sum, and smaller payments through the end of the contract. In either scenario, he would pay his regular tax rate on the interest portion of the cash received, but not the principle portion.

Unlike some other investments, such as real estate or stocks, annuities have no step-up in their basis, or original cost, at the owner's date of death. Many times, assets are worth more at the owner's death than when first acquired, but annuities have no change in value one transferred to the beneficiary. Annuities are included in the deceased person's estate, making them subject to estate tax. In this situation, the person inheriting the annuity must pay the estate tax on the annuity.