Ken Petersen for the Monterey Herald writes: Question: When my mother died, I learned that her bank had sold her two annuities. I am the beneficiary of one of them and a local charity is the beneficiary of the other. What are annuities, and what are the income tax ramifications when they are inherited, both for me and the charity?
Answer: Annuities are insurance products sold by licensed insurance agents working in banks, brokerage firms and insurance agencies. Sales of individual annuities reached $230 billion in 2013, according to LIMRA International, a worldwide association that provides research to insurance and financial services companies.
There are two broad categories of individual commercial annuities, fixed and variable. There are numerous variations and options for each type, which can be very confusing. In simple terms, when you purchase a fixed annuity you pay the insurance company a certain amount of money in exchange for a fixed rate of return. If you purchase a variable annuity, then you can select investments inside the annuity that are similar to mutual funds. The return on your investment depends upon the performance of those funds. For both fixed and variable annuities, you can buy an immediate version or a deferred version. Immediate annuities begin making payouts right away over whatever time period you select at time of purchase. Typical time periods include your single life, your joint life with your spouse, or a certain number of years. When the selected time period is over, the annuity payout ends and the annuity contract has no value. Deferred annuities do not begin payouts right away. Instead, they accumulate value. At some time in the future, when you are ready for income, you can end the "accumulation" phase and begin taking guaranteed payments.
Tax deferral is a big advantage of an annuity. Like money in a retirement account or IRA but unlike most conventional investments, the money that an annuity earns compounds with no immediate tax consequence. You don't pay income tax until you withdraw the money. Also, like retirement accounts and IRAs, when you die your beneficiaries inherit your annuity's tax basis and become responsible for any income tax due on withdrawals. The taxable portion of an inherited annuity (technically referred to as IRD or "Income in Respect of a Decedent") is the value of the annuity contract less the cost basis (usually the amount invested) in the contract. If the beneficiary is a qualified charitable organization, it does not pay any income tax.
A popular estate planning technique is to leave conventional assets like stocks and real estate, which receive a step-up in cost basis at death, to your children or other loved ones and to designate a charity as the beneficiary of a retirement plan, IRA or annuity. If you want to leave part of an IRA or annuity to your children you can try to split it into two or more accounts. IRAs are easy to split. Annuities can be more of a challenge. After a split, you can designate a charity as beneficiary on one of them and your children on the others. When you leave an IRA or annuity to a charity, you remove its value from your taxable estate and save your loved ones from some potentially onerous income tax consequences.
Kenneth B. Petersen is an investment adviser and principal of Monterey Private Wealth Inc. in Monterey.
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