Navigating the tax implications of an inheritance can be complex, especially when it involves an inherited annuity. The tax liability varies depending on factors such as how the annuity was funded, whether it’s part of a retirement account like a 401(k), and the specific type of retirement account.
Here are some essential points to understand about inherited annuities and how to calculate the associated taxes.
How are inherited annuities taxed?
The taxation of an inherited annuity depends on several factors, with a primary consideration being whether the money coming out of the annuity has been previously taxed (unless it’s in a Roth account). If the distributed funds have not been taxed before, they will be subject to income tax. Conversely, contributions that have already been taxed will not be subject to income tax again.
Beyond income taxes, you might also be subject to the 3.8 percent net investment income tax on distributions of earnings if your income exceeds the annual thresholds for this tax. Inherited annuities within an IRA come with special distribution rules and additional requirements for heirs, making it crucial to understand these regulations if you inherit such an annuity.
Qualified annuities
A qualified annuity is one where the owner paid no taxes on contributions, often held in tax-advantaged accounts like traditional 401(k)s, traditional 403(b)s, or traditional IRAs. These accounts are funded with pre-tax money, meaning taxes have not been paid on either the contributions or the earnings.
Since these are pre-tax accounts, all distributions will be subject to ordinary income tax. The annuity company will report this information on a 1099-R form filed at the end of the year.
Nonqualified annuities
A nonqualified annuity is purchased with after-tax cash, meaning distributions of the initial contributions are not subject to income tax because taxes have already been paid on them.
There are two main types of nonqualified annuities, each with different tax treatments:
- Regular nonqualified annuity: Purchased with after-tax cash in a regular account. Distributions of the contributed amount are not subject to income taxes, but any earnings distributed are taxed at ordinary income tax rates.
- Nonqualified annuity in a Roth account: Purchased in a Roth 401(k), Roth 403(b), or Roth IRA, which are all after-tax retirement accounts. Normal distributions from these accounts are tax-free on both the contributions and the earnings.
In either case, the annuity company will file a Form 1099-R at the end of the year, detailing how much of the year’s distribution is taxable, if any.
Annuities can offer significant tax advantages, including tax-deferred growth, so understanding their features can help you maximize these benefits.
Inheritance and estate taxes on annuities
Beyond income taxes, an heir may also need to account for estate and inheritance taxes. Whether an annuity is subject to income tax is separate from whether the estate owes estate tax on its value or whether the heir owes inheritance tax on the annuity.
Estate Tax: This is assessed on the estate itself. Estates with assets exceeding $13.61 million (in 2024) are subject to federal estate taxes on the amount above this threshold. The rates are progressive, ranging from 18 percent to 40 percent. Additionally, individual states may impose their own estate taxes on distributions from the estate.
Inheritance Tax: This tax is assessed on the individual receiving the inheritance, not on the estate. The U.S. federal government does not impose inheritance taxes, but six states do. These rates can be as high as 18 percent, and whether the inheritance is taxable depends on its size and the recipient’s relationship to the deceased.
Heirs of large annuities should be aware of potential estate and inheritance taxes, in addition to standard income taxes.
In Conclusion
Inherited annuities can be complex for recipients, but the key principle is that any distribution is taxable if tax has not been previously paid on the money, except when it’s in a Roth account. Additionally, heirs should be mindful of potential inheritance and estate taxes.