The beneficiary's basis in an annuity is the same as that of the decedent at the time of the latter's death. The basis of property is the amount that the taxpayer is credited with paying for it. For example, if the decedent paid $10,000 for an annuity, the beneficiary will take the annuity with that same $10,000 basis. Any income in excess of the basis is taxable income. Knowing how the basis is determined and applied for inherited annuities helps you report the distributions properly and not overpay on your income taxes.

## Annuities Purchased with Pretax Dollars

You may contribute pretax dollars to a qualified annuity. For example, if you purchase a qualified annuity for $5,000, you may take a $5,000 deduction on your income tax return. However, that means that all of the distributions from the annuity will be taxable on your federal income tax return. Most states follow the same tax treatment as the federal government, but some states may disallow a deduction for contributions. In such cases, however, the portion of the distribution that represents a return of contributions will not be included as taxable income on the state income tax return.

## Annuities Purchased with After-Tax Dollars

You are not permitted to deduct the purchase price of a nonqualified annuity in the year that you purchase it. Instead, the payment creates a basis in the annuity. Similarly, if you purchase an annuity with after-tax dollars, you have a basis in the annuity. When distributions are taken, the portion of the distribution representing a return of contributions is nontaxable. When you inherit an annuity purchased with after-tax dollars, the tax treatment is the same: The portion of the annuity that represents a return of contributions is tax-free and the earnings are taxable.

## Calculations

Annuities use either the simplified rule or the general rule to determine the tax-free portion of an annuity. The general rule is used for all nonqualified annuities as well as qualified annuities if you are 75 or older when the annuitant begins taking distributions or if the annuity payments are guaranteed for at least five years. To calculate the tax-free portion of payments, divide the total cost by the total expected return. For example, if the decedent had a basis of $10,000 and the expected return on the annuity is $20,000, half of each payment would be tax-free. The simplified method applies to qualified annuities that begin distributions before you reach age 75 or for which you are guaranteed less than five years of payments. To calculate the tax-free portion of the payments, divide the total cost by the number of anticipated monthly payments. For example, if the decedent had a basis of $30,000 in the annuity and the payments are guaranteed to last another five years (60 months), divide $30,000 by 60 months to find that $500 of each payment is tax-free.

## Exemption from Additional Tax

Typically, when a distribution is taken from an annuity before the owner reaches age 59 1/2, the taxpayer must pay a 10 percent additional tax penalty on any earnings distributed from the annuity. However, when the distribution is made to a beneficiary after the annuitant dies, the distribution is exempt from the penalty. The Form 1099-R that you receive from the financial institution should have "4" in box 7 to indicate to the IRS that the distribution is exempt from the penalty.

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