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.
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 35 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.
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. Michigan and federal pensions are state tax exempt, as are several other types of retirement income. Capital gains, interest and dividend income is exempt up to a certain amount if you're over 65. Private pension income is exempt up to $90,240 if you're married and $45,120 if you're single. Otherwise, Michigan imposes a flat income tax rate of 4.35 percent; this rate will be reduced by 0.1 percent per year over the next four years. In 2015, the rate will be 3.9 percent.
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, according to NewYorkLife.com. 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, according to Bankrate.com.