Immediate annuities guarantee a lifelong income and hence a veritable boon especially for retirees. Alternately, deferred annuities can serve as longevity insurance by providing a cushion and as a support for the retirement years to follow - to add to the other retirement income. And in both cases, the investor gets favorable treatment as the annuity tax always benefits for tax deferral or tax exclusion.
But the unfortunate part is that some retirees may pass away before availing themselves of the balance of their deferred annuity. The question is - what are the annuity tax implications to the beneficiary and whether there are alternatives to minimize annuity tax?
Lest we forget, a deferred annuity provides a unique tax-benefit - the growth in earnings is tax-deferred. Interestingly, the annual return of a tax-deferred investment compounds much faster than a taxable investment because none of its earnings are taxed on a year to year basis. Additionally, the fact that this income does not appear on a tax return in many cases, will reduce or even eliminate the tax on social security income benefits.
However, the fact remains that these tax-deferred earnings will attract annuity tax upon withdrawal - though your initial contributions to the annuity will not be subject to tax. This is true of 'nonqualified' annuities which are funded with post-tax contributions.
The annuitant is the person who receives payments on the annuity. If a withdrawal is made, the IRS interprets that the earnings come out first and accordingly subjects them fully to annuity tax. Whereas, under annuitization (regular monthly payments of principal and interest) – a part of each payment is free from annuity tax but is deemed as a return on your non-taxable contributions. The annuity company uses an exclusion ratio (and IRS dictated calculation) to calculate the untaxed portion. After the annuitant has got a number of payments and whereby all of his principal has been returned, then the remaining future payments are fully subject to annuity tax.
Now, we can look at the annuity tax for the beneficiary. Post-tax contributions made by the deceased owner will continue to remain untaxed when received by the annuity beneficiary. But, all those tax-deferred earnings within the annuity will be subject to annuity tax – in keeping with the usual income tax rates as apply to the beneficiary. If the annuitant had started receiving lifetime payments, then beneficiary will be left with no benefits. But if the contract entails fixed term assured payments, the beneficiary would receive the balance of the payments taxed at the deceased person's exclusion ratio.
If the annuity owner died prior to the commencement of annuitization, there is the option for a lump amount distribution or a stream of payments to the beneficiary. For the lump amount payment, the beneficiary will only pay annuity tax on the earnings portion. But in the event the beneficiary opts for a stream of assured payments, he need not pay taxes on any of the payments till the deceased owner's contribution is fully received. Payments after that would attract annuity tax at usual income tax rates.