taxes

How to figure tax on inherited annuity

George SaenzQuestionDear Tax Talk,
My wife inherited an annuity when her mother died last year. She received a lump-sum check. Does she have to pay taxes on the entire amount as normal income? Or does she owe tax to the extent that it exceeded her mother's basis? This is not an IRA and the annuity was purchased with after-tax dollars. I am leaning toward treating this as the same as inheriting cash.
-- Jim

AnswerDear Jim,
You're on the right track, but the inheritance is not the same as cash. Instead, the annuity is considered income in receipt of a decedent, or IRD. IRD is the income element of inherited property. For example, if you receive an IRA as a beneficiary, it is income to you as it would have been income to the decedent.

In a traditional annuity, an investor turns over a sum of money, usually to an insurance company, that agrees to pay the investor a certain amount of money over a period of time. Some annuities begin immediately and some are deferred until some future event, such as the beneficiary reaching a certain age. Whether it is an immediate or deferred annuity, each part of the payment represents a return of the original investment, plus the earnings on the investment. The earnings are taxable over the life of the payments.

Because your wife chose to cash in the annuity, a portion of what she received will be income from the invested funds. The insurance company should be able to tell her what amount is income. In this sense, it is not the same as inheriting cash.

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To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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