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Retirement Weekly: What are the tax rules around inheriting an annuity?

Q.: Dan, I read your answer to the question about inheriting an annuity. Does it even matter what the cost basis is? Don’t investment assets get a step up?

– Kenny

A.: Kenny, some investment assets get a step up in basis upon the owner’s death but not all. Similar to U.S. savings bonds, traditional IRAs, 401(k)s, 403(b)s and other retirement plans, there is no step-up on nonqualified annuities. Annuities provide tax deferred, not tax-free income. Those deferred earnings are considered “Income in Respect of a Decedent” after the original owner’s death and are taxed as ordinary income when paid to the beneficiary.

With a nonqualified deferred annuity, you buy into a contract with an insurance company. The earnings are not taxed until you take money out.

So, say you buy a nonqualified deferred annuity with $100,000 and have it grow to $200,000. Unless the contract was purchased prior to Aug. 14, 1982, the first dollars removed are deemed to be earnings and are taxable to the owner of the contract.

Need $20,000 for some repairs? All $20,000 withdrawn from the annuity will appear on your tax return as ordinary income. At that point you have a $180,000 account of which $100,000 is cost-basis that will never be taxed and $80,000 is earnings, taxable to you when you take it out. As Income in Respect of a Decedent, the $80,000 is taxable as ordinary income to any beneficiary that receives after your death.

If a contract is annuitized — converted to a stream of contractual payments — a portion of the payment will be a return of basis and not taxed but those deferred earnings are still going to be taxable as received.

Contrast that to an investment in a traditional taxable account valued at $200,000 with a basis of $100,000. Need $20,000? The tax is calculated differently and is based upon the ratio of gain to cost-basis. To get $20,000 in cash, you sell enough shares to create $20,000 in proceeds. In this case, of that $20,000, $10,000 is a capital gain ($100,000/$200,000 = ½. Half of $20,000 is $10,000). Only the $10,000 of gain is reported on your tax return.

In addition to calculating the amount that appears on your Form 1040 in a different manner, long-term capital gains (gains on holdings held for more than 12 months) are taxed at different rates than ordinary income. Long-term capital gains rates are lower than the rates on ordinary income for all taxpayers regardless of income level. Depending on your taxable income, a $10,000 gain is taxed at anywhere from 0 to 23.8% on the federal level. Ordinary income rates go as high as 40.8% currently (37% plus 3.8% of Net Investment Income Tax.

After taking the $20,000, at that point you have a $180,000 account. $90,000 is cost-basis which will never be taxed and $90,000 is unrealized capital gains. These gains are taxable when you sell the holding.

If the holding was worth $180,000 on your date of death, assuming you are the sole owner, the cost-basis of the entire holding is “stepped-up” to $180,000. Your heirs could then sell the holding and calculate their gain or loss based upon a basis of $180,000, not $90,000. If they sold for $180,000 they would pay no income or gains taxes.

Nonqualified deferred annuities can be useful tools, but they are subject to unique tax rules. Sometimes those rules can work to your advantage but if you are not careful, you may enjoy avoiding taxes on earnings in the present only to regret creating a larger tax bill for you or someone else in the future.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line. 

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide but with offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.

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