Tax-deferred annuities are investment products typically offered by insurance companies. People purchase them either through an employer's retirement plan or independently through an insurance company or financial planner that works with a broker. Annuities are contracts that pay regular payments to provide income during retirement, and they come with a payment guarantee made by the issuing insurance company. If you've inherited an annuity, you may owe taxes on some or all of the proceeds, depending on what type of contract the original owner purchased.
If you have inherited a tax-deferred annuity, your specific tax obligations are largely contingent on how distributions are managed. For example, a beneficiary can choose to pay taxes periodically by distributing payments from the annuity over a period of time. Or they can pay a lump sum of tax on the entire annuity if they wish to withdraw all of the funds immediately. If the annuity is non-qualified, it will not receive a step-up in basis, which could directly impact tax obligations.
What Does Tax-Deferred Mean?
Deferring the taxes on an investment means postponing taxes on any interest growth or capital appreciation while the investment grows during a person's working years and not all annuities are tax deferred. Once the original account owner or an heir starts taking distributions, whether in payments or in one lump sum, the money is taxed at the individual's regular tax rate. In some cases, if the tax-deferred annuity is non-qualified, no taxes are due on the principal portion when it's paid out.
Taxation and Qualified Versus Non-Qualified Status
Annuities with a qualified status are taxed like an IRA, 401(k) or other retirement account. The account is funded with pre-tax dollars, and the annuity is usually purchased through a workplace retirement plan. Because qualified plans are funded with pre-tax dollars, both the principal and the growth must be taxed when taken out of the account upon the owner's retirement or a distribution to an heir.
Non-qualified annuities carry this name because they do not qualify to receive pre-tax contribution dollars. Account owners fund these annuities with after-tax dollars. These annuities are typically purchased outside of workplace retirement plans, through a financial planner or directly from an insurance company. Because taxes were already paid on the original principal before it was contributed to the account, once the money is withdrawn at retirement, the owner or heir pays taxes only on the growth.
Annuities Estate Tax Implications
If the owner of an annuity designates a spouse as beneficiary, the spouse can continue contributing and receiving tax-deferred growth, and receive the same tax treatment, as if he were the original account owner.
However, non-spouse beneficiaries inheriting an annuity must take distribution of the funds, either in a lump sum or in payments. If the annuity was a qualified plan, a person inheriting the money pays regular tax on all of the cash. If the annuity was a non-qualified plan, meaning that it was funded with after-tax dollars, the person inheriting would pay tax only on the growth portion of the money.
Choosing Periodic Distributions or a Lump Sum
The inheriting beneficiary can choose to take periodic payments from an annuity to spread out the tax liability over several periods, rather than having a large amount of income with the corresponding tax liability all in one tax year. Additionally, when someone inherits an annuity, it's treated differently than some other investments that need to have their values updated, or "stepped up," as of the owner's date of death. If it's a non-qualified annuity, it does not receive any step-up in its basis upon the owner's death.
- Edward Jones: Annuity Taxation
- Vanguard: A Straightforward Look at Annuities
- John Hancock Investments: The Benefits of Tax Deferral
- CBC Settlement Funding: Inherited Annuities
- CPA Site Solutions: Annuities: How They Work And When You Should Use Them
- Internal Revenue Service. "Retirement Topics - IRA Contribution Limits." Accessed Sept. 10, 2020.
- Internal Revenue Service. "Traditional and Roth IRAs." Accessed Sept. 10, 2020.
Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer for online finance publications since 2011, including eHow Money, The Motley Fool, and Sapling.com. She has also edited for several online finance publications, including The Balance, Opposing Views:Money, Synonym:Money, and Zacks.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.