Taxation of inherited annuities

Separate three situations before calculating tax: (1) a nonqualified deferred-annuity owner-annuitant dies before the annuity starting date; (2) annuity payments had already begun before death, including a joint-and-survivor annuity; or (3) the annuity is held inside an IRA or retirement plan. Rev. Rul. 2005-30 addresses the first situation. Post-starting-date payments follow the applicable IRC § 72 payment rules, while qualified-account taxation also depends on pretax basis, Roth status, and IRC § 401(a)(9).

A qualified annuity is held in an IRA or retirement plan. Its tax result follows the account’s pretax and after-tax contribution history as well as beneficiary distribution rules. A nonqualified annuity was purchased outside a qualified retirement account, usually with after-tax dollars.

Do not rely on the word “annuity” alone. Ask the insurer or custodian to confirm the account registration and the decedent’s recorded investment in the contract.

For a nonqualified contract, the roles decide whose death matters. Before choosing a payout, identify the contract holder or owner, annuitant, and beneficiary. For a nonqualified annuity, IRC § 72(s) generally keys the statutory after-death distribution rules to the death of a holder. If the holder is not an individual, the primary annuitant is treated as the holder, and a change in the primary annuitant is treated as the holder’s death. The contract may separately define when an annuitant’s death triggers a death benefit, so both the statutory event and the contract event must be checked.

For a nonqualified annuity subject to IRC § 72(s), if a holder dies after the annuity starting date, the remaining payments must continue at least as rapidly as under the distribution method in effect at death. If a holder dies before the annuity starting date, the remaining interest generally must be distributed within five years, subject to the designated-individual and surviving-spouse rules in § 72(s)(2)-(4). An annuity held inside an IRA or employer retirement plan is governed principally by IRC § 401(a)(9) and the qualified-account rules instead.

Those rules set the timing. The sections below set the tax character of what is paid.

When the facts fit Rev. Rul. 2005-30, the amount above the owner-annuitant’s investment in the contract is income in respect of a decedent under IRC § 691, whether paid in a lump sum or as qualifying periodic payments, and it does not receive an IRC § 1014 basis adjustment. If a survivor annuity continues after the annuity starting date, do not apply the ruling as though the facts were identical; IRC §§ 72 and 691(d), the Treasury regulations, and the applicable survivor-payment method control. The IRC § 691(c) deduction is limited to federal estate tax attributable to the IRD item. By its terms, Rev. Rul. 2005-30 applies to deferred annuity contracts purchased on or after October 21, 1979; contracts purchased before that date remain subject to the prior rulings, under which the death benefit could receive a basis adjustment.

IRD generally keeps the income character it would have had for the decedent. That is why the gain covered by that ruling — a death before the annuity starting date — generally does not receive the basis step-up commonly associated with some capital assets.

A lump sum can recognize the taxable gain in one year. Periodic payments can spread recognition, but each payment’s taxable portion depends on the applicable section 72 method and the contract’s payout form.

IRS Publication 575 explains survivor and beneficiary treatment. For a deferred annuity death benefit received before the annuity starting date, it describes the amount above the decedent’s cost as IRD. For qualifying annuity payments, an exclusion ratio or other applicable method determines the return-of-investment portion.

If federal estate tax was attributable to an IRD item, the recipient may be able to claim a section 691(c) deduction. This is not a blanket deduction for inheriting an annuity and does not mean state inheritance tax is deductible in the same way.

IRS Publication 559 explains IRD reporting and the potential estate-tax deduction. The estate’s Form 706 and the allocation calculation are important records.

Death does not eliminate ordinary income tax on the taxable portion of a distribution, but it can affect the separate 10% additional tax. Qualified-plan and IRA distributions made to a beneficiary or estate after the participant’s death generally fall within IRC § 72(t)(2)(A)(ii). Nonqualified-annuity distributions made after the holder’s death, or after the primary annuitant’s death when the holder is not an individual, generally fall within IRC § 72(q)(2)(B). A spouse’s later withdrawal after converting the asset to the spouse’s own account may have a different result.

• The insurer’s cost-basis and gain statement
• Form 1099-R and any corrected form
• The contract and beneficiary settlement election
• IRA or plan contribution basis records, including relevant Form 8606 history
• Estate-tax return and IRD allocation support, if a section 691(c) deduction may apply

Assume a nonqualified deferred annuity whose owner-annuitant died before the annuity starting date. If the insurer reports an investment in the contract of $80,000 and a lump-sum death benefit of $110,000, the $30,000 excess is generally the starting taxable amount under the deferred-annuity IRD rule. Real cases can differ because of prior withdrawals, multiple beneficiaries, post-death changes, and contract-specific reporting.