Annuities are insurance policies that guarantee you an income for retirement. However, annuities do not receive the same benefits that life insurance receives in regard to taxation. When you receive an annuity as part of your inheritance, you must pay tax on the distribution. However, you should understand both the type of tax, and the choices you have as to how to pay the tax.
You may elect to receive a lump sum distribution from your inherited annuity. This means that you take the full account balance of the annuity when the original annuity owner dies. If the annuity is not inside of a qualified retirement plan (i.e., an IRA), then you pay tax only on the gains in the annuity. Any investment principal of the annuity is not taxed. If you receive an annuity inheritance from a traditional IRA, you must pay tax on all of the proceeds. If you receive your annuity from a Roth IRA, none of the proceeds are taxable.
You may elect to receive payments over your lifetime from an annuity inheritance. The benefit of this approach is primarily if you have received an annuity not inside of an IRA. When you take annuity payments in this scenario, most of the payment is considered a return of principal with a small amount of interest added to the payment. Because of this, you pay a relatively small amount in taxes. The same rules apply to monthly payments when receiving money from an IRA. Traditional IRA payments are fully taxable and Roth IRA payments are tax-free.
The type of tax you pay is income tax, not capital gains tax. The tax is based on your personal income tax rate. Any income you receive from the annuity is added to your gross income. This means that if your inheritance forces you into a higher tax rate, all of your income is subject to this tax rate. This may, in turn, force you to pay higher taxes overall for the year(s) you receive your inheritance.
If you are receiving an annuity as an inheritance, consider your own financial goals prior to choosing a payment option. If you are in need of a lump sum of cash, or if the annuity is in a Roth IRA, it may be best to take the entire lump sum of money now. If you are being taxed on some or all of your inheritance, you may be best served by spreading your annuity inheritance out over your lifetime to reduce the negative impact of paying taxes on your inheritance.