An annuity is a tax-deferred savings account. Most annuities are retirement accounts; account holders can deposit money, but cannot withdraw it until they reach age 59 1/2. If an annuity owner dies, the beneficiary of the account is entitled to distributions from it. The tax requirements on such distributions vary, based on the type of annuity and whether the decedent was still working at the time of death.
Same as Deceased
In most cases, the Internal Revenue Service taxes inheritance income from annuities the same way it would tax the income if the original owner of the annuity received it. For example, if the annuity holder would report income and pay taxes on it, the beneficiary must report the income and pay taxes on it.
If a beneficiary entered a contract with an annuity holder that promised her lifetime benefits after his death, her benefits are handled differently than other annuities. Her distributions will be tax-free until such time as her total distributions plus any distributions the decedent took equal the cost she paid when she entered into the contract.
Annuity payments are taxable if the deceased person was retired at the time of his death. If the retiree had used the "three year rule" to exempt himself from taxes on his annuity payments, the beneficiary's annuity payments are 100 percent taxable. If the retiree used the simplified method or general rule to exempt a portion of his annuity payments from taxes, the beneficiary must use the same method to determine the percentage of taxable benefit payments.
If the decedent was employed at the time of death, her beneficiary's distributions are handled similarly to that of a retired decedent's. The beneficiary may exclude from income lump sum distributions up to the cost of the annuity contract -- in other words, distributions that would have allowed the decedent to cancel the annuity if she were alive. If the beneficiary receives periodic distributions, she must calculate the tax-free portion of the distributions using the simplified method or general rule.