Mom is worried about tax hit from annuity

Dear Dr. Don,
When my mother died a decade ago, I took $50,000 of my inheritance and put it into a fixed-rate annuity. The balance is now $65,000. I did not pay inheritance tax on the original $50,000. Is it better to leave the annuity alone and let my children inherit it or should I take a lump-sum distribution now? What would the tax bill be on this?

Thank you,
— Trudy Taxed

Dear Trudy,
Since you put the money into a tax-deferred fixed annuity, the investment earnings are taxed when the money comes out. Your cost basis of $50,000 isn’t taxable, but the investment earnings are taxed as ordinary income.

How the annuity distributions are taxed depends upon whether you “annuitize” the balance, or you take the money as a lump sum. There’s no rise in the basis (or taxes owed) if your children inherit the annuity. Depending on the size of your estate, there may be estate tax implications. There could be inheritance taxes due as well.

In general, it’s the estate’s responsibility to pay federal or state estate taxes due from the value of the estate. Inheritance taxes are different from estate taxes, however, and are charged to the beneficiaries. Currently only six states and the District of Columbia have inheritance taxes. There have been a lot of changes over the years. Relevant here are the tax laws in place when you inherited the funds.

Whether inheritance tax was due 10 years ago would depend on the size of your mother’s estate and her state of residency. Inheritance taxes are paid by the executor or person representing the estate before the assets are given to the beneficiaries. At this point, your tax issues are mostly income tax-related.

I sense that you don’t want to take a tax hit and are reluctant to tap this annuity. Other than the annuity, you haven’t provided details of your finances. So, it’s hard for me to say what you should do with the annuity. To me, paying income taxes on a $15,000 gain isn’t a reason to let taxes guide you when deciding whether to use the annuity during your lifetime, or to have your children inherit the tax burden along with the money.

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