Most investors don't realize the potential tax implications of inheriting an annuity until faced with an unexpected bill.
A boom in annuities -- more than $1.7 trillion is now backing these investments in the United States -- has occurred as more people plan for retirement.
A substantial tax hit can be an unexpected effect as more children and even grandchildren receive an annuity windfall. Other problems may include getting stuck with an annuity geared to the needs of a retiree, or one that is highly illiquid.
"There seems to be an insatiable demand for these products as more people are facing retirement, but most people who invest in an annuity have very little understanding of the tax implications," said John Nersesian, managing director of wealth management services at Nuveen Investments Inc.
Though annuities offer a number of advantages, tax treatment isn't generally one of them. Annuity payments are typically taxed as ordinary income, which can go as high as 35 percent, rather than at the capital gains rate, even if the investments in the annuity have made money.
"It is all ordinary income, and that's a bit of a disadvantage given that we have 15 percent [tax rate] on capital gains and qualified dividends," said Thomas P. Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants.
When a person inherits an annuity, the gains stay with the policy. Tax will have to be paid on the lump sum received or on regular fixed payments, depending on the type of annuity.
Another thing to remember: While annuities pass to heirs or beneficiaries outside the probate process, they're still part of the estate when figuring estate tax. So, beneficiaries may have to pay estate tax even if they won't be getting the annuity payments for a long time.
"Most people think of an annuity as a stream of future income, but don't necessarily recognize it as an asset included in the decedent's estate," said Nersesian.
For estate-planning purposes, a parent or grandparent may want to consider selling an annuity in favor of a life insurance policy. The measure could provide a guaranteed death benefit that would pass to heirs without gift or estate tax.
"To get the tax benefit, the life insurance must be set up appropriately with the help of a tax professional," said Michael Vaughan, managing director of the annuity purchase program at J.G. Wentworth, in Bryn Mawr, Pa., a specialty finance company that purchases annuities in the secondary market.
In an example provided by J.G. Wentworth, a man owns a $1.1 million annuity that provides him with 20 years of guaranteed monthly payments. If he died, his daughter would owe estate taxes equal to 45 percent of the annuity's present value, around $500,000, for the purposes of the example. In addition, any gains from the underlying investments in the annuity contract could be taxed at her ordinary income tax rate.
Four years after buying the annuity, the man decides to sell a portion of it, say $4,000 of the $7,865 that he otherwise would have received each month for the next 16 years, for a total of $448,910. He uses it to fund a life insurance policy with a face value of $1.6 million, which is established as an irrevocable trust.
He would continue to receive $3,865 of his regular monthly payments for the next 16 years. But if he now died, his daughter would inherit $1.6 million tax-free in death benefit from the insurance policy. If he had kept the full annuity in exchange for the insurance policy, she would have owed 45 percent estate tax on the $1.1 million value of the annuity, according to the example.
Here are a few things to consider: Does the beneficiary have the ability to roll over or continue income tax deferral on the payments? Will including the annuity in the estate-tax calculation result in double taxation -- estate and income?
Another thing to consider is whether any beneficiary other than a spouse will have to pay income tax on the annuity gains when they are distributed.
Heirs should also find out if they can cash it in for an investment with lower tax consequences.
Arden Dale is a columnist for Dow Jones Newswires. She can be reached at firstname.lastname@example.org.