Minimizing Taxes on Inherited Assets Part 2: Annuities

  • By Franklin A. Drazen
  • |
  • Posted December 6, 2016

If you’ve just inherited an IRA, annuity, stocks, bonds, or other assets from your parents, minimizing your tax obligation needs to be addressed. What do you need to know to keep Uncle Sam from taking more than his share when you file your tax return? In this three-part series, Attorney Franklin Drazen covers a few of the basics. This week, we look at annuities.

Inherited retirement accounts like IRAs and annuities and assets like stocks and bonds live at the tricky three-way intersection of estate planning, financial planning and tax planning. That’s why I advise my clients who’ve inherited these assets to do nothing until we’ve met to explore their options. When you inherit assets from a deceased parent, your actions will determine your tax bill. The worst thing to do is to cash out the plan, put it in your account, and then come to see me saying, “Now what?” Though IRAs and annuities are often established to grow money on a tax-deferred basis, the way they are viewed from a tax perspective is very different. This week, we look at annuities.

Annuities are insurance products that allow a person to invest money that can grow tax deferred and provide a source of monthly, quarterly, annual, or lump sum income during retirement. An annuity can make periodic payments for a certain amount of time, or until a specified event occurs (for example, the death of the person who receives the payments). Unlike an IRA, which can have only one owner, an annuity can be jointly owned and typically will name one or more beneficiaries to receive the annuity when the owner dies.

Annuities are fundamentally a life insurance product, which alters how they are handled for taxation and inheritance purposes. If your parent had a deferred annuity, he or she made an initial investment and it grew over time. Your loved one was probably told at the point of sale that no taxes would be payable on the income generated by the annuity until withdrawals begin. Your parents probably really liked the sound of that, especially if they were concerned about needing extra money in retirement.

But here’s the rub. Many people never get around to taking withdrawals because there are other sources of income to fund their retirement. So when these people die, their beneficiaries—most often their children—end up with a big surprise when they start withdrawing funds from these accounts.

For all annuities purchased after 1985, an annuity’s earnings are withdrawn first and are therefore subject to taxation. All withdrawals are taxable as ordinary income until the account value reaches the initial amount invested. Distribution of the initial investment is a non-taxable return of capital. Because annuity income is considered income in respect of a decedent (IRD), it is taxable at ordinary income tax rates, and you don’t get the benefits of the stepped up basis and lower capital gains tax rates available from inherited stocks, bonds and mutual funds. I’ll discuss that in next week’s blog.

If you inherit an annuity that’s not part of an IRA (yes, IRAs can purchase annuities but that’s a more complicated post for another time), you can recover the initial investment in the annuity, also known as the basis, as mentioned above, without paying taxes. There are some adjustments you can make to your basis depending on the amount of estate taxes paid on your parent’s estate.

Sound confusing? It is. The tax laws governing the transfer of assets from one generation to the next are complicated, frustrating and arcane. Fortunately for you, the professionals at Drazen Law Group are well equipped to help you develop a strategy that will make sure that family wealth ends up where your parents wanted it to be. Just give us a call at 203.877.7511.

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