The Taxes on the Inheritance of a Tax-Deferred Annuity

As insurance products, annuities have unique attributes that other investments lack. When the person who owns an annuity dies, the death benefit goes to the named beneficiary, and there are tax consequences for the person who inherits that death benefit.

Beneficiary choices and tax consequences The named beneficiary on a tax-deferred annuity typically has several options on how to receive the death benefit. Which option the beneficiary chooses has a substantial impact on how the proceeds will get taxed.

The easiest way to accept an inherited annuity is to receive the entire amount in a lump sum. The problem with taking a one-time lump sum is that you trigger tax on the entire amount of deferred income that the annuity generated. So if the annuity buyer paid $10,000 and the death benefit was $100,000, the heir would immediately owe tax on the remaining $90,000.

However, annuity heirs can also elect to take payments over a longer period. You have up to five years after death to receive payments, and you'll only owe tax on the amount of income that corresponds to the portion of the annuity that you withdrew during that give year. Different tax details apply depending on when the annuity was issued, but in general, spreading out payments helps keep you from climbing into a much higher tax bracket.

The beneficiary also has the right to take death benefit payments over their lifetime. This spreads out the tax consequences to the maximum extent possible, but it also requires patience in waiting to receive the money.

A special option for surviving spousesFinally, surviving spouses of annuity owners have an extra option. They can switch the annuity contract into their own name. That avoids immediate tax consequences, and from there on out, the contract is treated for tax purposes as if the surviving spouse were the original owner. The spouse also has the right to use any of the distribution methods mentioned above, but often, this special option will provide the best possible tax treatment for all involved.

Inheriting an annuity requires smart choices in a relatively short time frame. By thinking about the various options you have, you can ensure that you'll make a smart choice that fits your financial planning.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us atknowledgecenter@fool.com. Thanks -- and Fool on!

The article The Taxes on the Inheritance of a Tax-Deferred Annuity originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.