Annuities & Taxes at Death
Annuities are complex investment vehicles sold by insurance companies. Annuities provide tax deferral and the option to create a lifetime stream of income. Taxation at death depends on form of ownership, basis in the contract, and whether or not lifetime payments have begun. Annuity death benefits are income in respect of a decedent (IRD) for estate purposes.
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Types
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Qualified annuities are those annuities held in an IRA or qualified retirement plan. A non-qualified annuity is any annuity not held in a qualified plan.
Qualified Annuities
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Death benefits from qualified annuities are taxed on the basis of the qualified plan. The proceeds of the contract are taxable to the beneficiary to the extent the proceeds exceed any non-deductible contributions to the plan. If the annuity was held in an IRA, then IRA distribution rules apply; the beneficiary has the option to take distributions based on life expectancy or under the five-year rule. The five-year rule allows distributions to be taken within five years.
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Time Frame
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If death of the annuitant occurs before payment from a non-qualified annuity has begun, then the beneficiary includes in income the value of the annuity contract in excess of the cost basis in the contract. The cost basis is the sum of payments made to a non-qualified contract less prior distributions.
Joint and Survivor Annuities
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Beneficiaries of a joint and survivor annuity which was in payment at the time of the annuitant's death must calculate the taxable and tax-free portions of payments under the IRS's General Rule. The general rule allocates payments to tax-free and taxable portions based on a ratio of the contract's cost basis and the total expected payout from the contract.
Guaranteed Payments
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Beneficiaries receiving guaranteed payments exclude the amount of these payments from income until reaching an amount equal to the cost basis in the contract; payments received after this are included in income. This rule only applies if payments cannot exceed the amount guaranteed under the contract; generally this excludes this rule from applying to any payments based on the beneficiary's life expectancy.
Considerations
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Taxable income received by a beneficiary under an annuity contract is taxable in the year it is received. Postponing receipt of distributions postpones the need to pay the taxes.
Misconceptions
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The Internal Revenue Service considers any income the decedent had not received, but would have received had they continued to live, to be income in respect of a decedent. Income in respect of a decedent is includable on the decedent's estate tax return. The beneficiaries are responsible for the tax on this income; if inclusion of this income in the estate results in estate taxation the beneficiaries may be eligible for a corresponding deduction of this amount as a miscellaneous deduction on their income tax returns.
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References
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