Dear Tax Talk,
If I name my daughter as inheritor of my nonqualified annuity, will she owe taxes on it when she inherits it after my death? My total estate will be well below $5 million and the annuity is for $100,000.
— Jan

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Dear Jan,
To the extent your daughter, as the beneficiary, receives any deferred income from the annuity, this will be considered ordinary income to her and will be taxed accordingly.

Nonqualified annuities are not taxed the same as other investments. First of all, a nonqualified variable annuity grows tax-deferred until you start taking withdrawals, which are taxed at ordinary income tax rates.

Policies purchased after Aug. 14, 1982, require that all withdrawals are taxed until the account reaches the original amount invested. However, if the payments are annuitized, then a calculation will be done by the insurance company and a portion of the annuity payment will be considered a return of premium and will not be taxable at that time.

Other annuity considerations:

  • There is no step up in basis to the date-of-death value.
  • The annuity is included in your estate for estate tax purposes.
  • For a non-spousal beneficiary such as your daughter, the earnings are taxed at ordinary tax rates.
  • Spousal beneficiaries, however, may be able to continue the tax-deferred growth, depending on the specific annuity.

Your daughter will have the choice of taking a lump-sum payment or receiving the payments over a period of time. By spreading the payments over several years, the income may be taxed at lower rates, but it will depend on her specific tax situation.

Thanks for the great question and all the best to you with your estate planning.

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