When you inherit investments or other property from someone who has died, including annuities that appreciate in value, the federal government doesn't require you to pay income tax at the time you receive it. However, there will be income-tax implications once you begin receiving distributions from the decedent's annuity. But you will only pay tax on the portion of the distribution that represents gain.
Alternative Annuity Treatment
Federal tax law generally allows you to receive a "stepped-up" basis in all property you inherit from a decedent. This means that you calculate your capital gain on the sale of your inheritance using the fair market value of the property as of the person's date of death as your tax basis. However, the IRS treats the inheritance of an annuity differently than most other types of property. The difference is that your tax basis is the same as the decedent's, meaning it's not stepped-up, and the gain or income you receive is subject to ordinary rather than capital-gains tax rates.
Guaranteed Payment Annuities
Some annuities provide beneficiaries with a guaranteed payment amount in exchange for a fixed contribution. If you inherit this type of annuity, the distributions you receive are not taxable until you recover the decedent's entire annuity investment back. For example, if the decedent pays $25,000 for an annuity contract that guarantees future income of $50,000; the first distribution that is taxable to you occurs after the cumulative payments that you and the decedent receive reach $25,000. Every distribution you receive thereafter is taxable income.
Other types of annuities provide the beneficiary with a lump-sum payout amount in the event the decedent dies before receiving their first annuity payment. If you receive this type of payment as a result of an annuity the decedent purchases, the lump-sum payment is tax-free up to the amount of the decedent's cost. However, the excess is taxable income to you in the year you receive it.
Decedent's Employer-Provided Annuity
When the decedent designates you as the beneficiary of an employer-provided annuity, the tax treatment is different than the private annuities you inherit. The IRS imposes the same tax obligations on you that would apply to the decedent if still living and receiving the annuity payments. This requires that you include in taxable income the portion of each annuity payment you receive that exceeds the decedent's contribution, or tax basis. For example, if the decedent's total contribution to the annuity was $10,000 and it entitles him or his beneficiary to receive 10 annual payments of $5,000; the taxable portion of each annual payment you receive is $4,000 since the $1,000 is a recovery of the decedent's contribution.
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