Annuities

Today TaxMama® has been hearing from several people in the TaxQuips Forum and elsewhere, with this question. “Someone just inherited an annuity. Is it taxable? And if so, how much of it is taxable?”  

 

 Dear Family,  

Generally, in the United States, inheritances are not taxable to the heirs. The estate pays any taxes that are due. Though, most people are not affected by federal estate taxes, since they can generally exclude over one million dollars of assets per person.  

Currently, through the end of 2012, that exclusion is $5 million. We expect that to drop to about $3.5 million next year. Most Americans do not have estates that large.

However, there are certain assets that are subject to both taxation by the estate (if the estate is large enough) and to income taxes paid by the heir. These are the IRAs, pension plans and annuities (and U.S. Savings Bonds). Since most of these assets, or their earnings, have never been taxed, the heir pays the income taxes.

What is taxed? In regular IRAs – everything. Unless the deceased had a basis in the IRA (there were some years when the contributions to the IRA were not deductible), everything in the IRA is taxable.

With respect to pensions, lump sum or paid in installment, the same rule holds. If there is a basis (after-tax contributions by the deceased), that part is not taxed. 

When it comes to annuities, there was usually a substantial lump sum paid to buy the annuity. That isn’t taxed. Everything else is.  

This is where tax planning comes in – before and after death. Before death, it’s wise to review a person’s assets to see if there is an accumulation of assets that will be taxed to the heirs. If at all possible, start converting those assets from IRAs, pensions and annuities to Roth IRAs or after-tax assets.  

Consider someone facing large medical expenses, like for assisted living facilities. The $50,000 or so worth of medical deductions will often allow for $35,000 or so worth of extra income at a 0% – 15% tax bracket. 

After death, the heirs often have the option of receiving these taxable assets all at once or over 5 years or more. Getting the inheritance all once often puts them into the highest tax bracket – losing a substantial part of the inheritance to taxes. By getting the money over several years, not only are the taxes lower; but the money lasts longer, as well.

And remember, you can find answers to all kinds of questions about estates and inheritances and other tax issues, free. Where? Where else? At www.TaxMama.com.

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