The Tax Rules for a Non-Qualified Annuity at Someone's Death
When you inherit a non-qualified annuity, you must attend carefully to the rules regarding how it will be taxed. Since these annuities are not taxed in the same way as qualified annuities, the distribution will be somewhat different than if the annuity were being paid out from an IRA or a 403b plan.
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Features
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Non-qualified annuities are not qualified under the rules set forth under the Employee Retirement Income Security Act. This act outlines certain rules and provides certain protections for some types of investment accounts, including 401k plans and certain annuities found inside of employer-sponsored IRAs and 403b retirement plans. Because non-qualified annuities fail to meet the requirements of ERISA, all contributions to the annuity are after-tax. This changes the rules for distributions from the annuity.
Taxes
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Annuities may invest in mutual funds or the insurer's fixed interest account, or they may be invested in an insurer's equity indexed options strategy. Regardless of the investment, the annuity is subject to income taxes. Unlike other investments, which are subject to capital gains, annuities are treated as ordinary income. They may prove disadvantageous since your income tax bracket may be negatively affected by an annuity inheritance.
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Flexibility
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Even though the tax paid is income tax, you still have flexibility in how you pay those taxes. Also, in all cases, only the investment gain is taxable. To calculate the gain, you must subtract the total principal amount from the accumulated value of the annuity at the death of the original owner. Any value that exceeds the principal amount is taxable. Fortunately, you may spread this taxable amount out over your lifetime by electing lifetime payments. Under this arrangement, some of the money from the annuity will be returned to you as principal while the rest will be interest.
A Consideration
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You should consider taking annuity payments over your lifetime when you inherit a non-qualified annuity. Even though only the gains are taxable, you might be able to offset some of the tax payments with interest earned on the payments. Your insurance company will convert the entire inheritance to payments for you, guaranteeing a payment for your life. However, the company also pays interest on the payments it makes to you, which means that more of your inheritance gets to you, even though the IRS will assess income tax on the interest you earn on your payments as well as the investment gain on your inheritance.
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