Annuities are insurance contracts that guarantee an income to you during your retirement. If you don't use all of the money before your death, the annuity may be passed on to your beneficiaries. Unlike life insurance, annuities are subject to taxation. Make sure you understand how annuities are taxed if you plan to give your annuity to your heirs or if you are the beneficiary of an annuity.
Income from an annuity does not have to start immediately when you retire, although the most basic forms of an annuity convert your life's savings into an immediate income stream. Some annuities defer this payment until you want to receive the money. The former type of annuity is called an immediate annuity. The latter type is a deferred annuity.
Immediate annuities guarantee you an income for your lifetime or for a set number of years. These annuity payments consist mostly of a return of your investment principal with a small amount of interest added to the payment. Only the interest is taxable. Deferred annuities defer the guaranteed annuity payments. None of the money inside the deferred annuity is taxable until you start withdrawing money from the annuity or you convert the deferred annuity to an immediate annuity.
When an annuity is passed on to a beneficiary, the annuity's tax status does not change. This means that any immediate annuity payments that go to the beneficiary are taxed at ordinary income tax rates. For deferred annuities, the beneficiary has a choice between taking a lump-sum distribution from the annuity or taking immediate annuity payments. Regardless of the annuity, taxes are paid at the beneficiary's marginal tax rate.
The amount of taxes paid on an immediate annuity are lower than on a deferred annuity lump-sum distribution. This is because most of the annuity payment is a return of principal. In some cases, the immediate annuity payment is between 94 and 96 percent principal, with the remaining 4 to 6 percent constituting interest. In many instances, the interest paid is less. With deferred annuities, the tax is on all of the gains in the contract. You pay this tax in the year that you receive the funds.
Before deciding how to accept your immediate annuity inheritance, consider what you need the money for. While a lump-sum distribution may get your inheritance in your hands quickly, it is also an expensive way to get your inheritance. Unless you have an immediate need for a large sum of money, the annuity payments over time will likely be ideal from a tax perspective. Receiving your inheritance in a lump sum may increase the tax you pay on all of your earned income as well. This is because annuities are taxed at ordinary income tax rates and are added to your gross income for tax purposes. If the annuity's gains push you into a higher tax bracket, you'll pay higher taxes on all of your income, not just your inheritance.