One of the most attractive features about annuities is that they pass directly to their beneficiaries, bypassing probate, upon their owners' death. They're an effective way of making cash available to a family when all other assets are frozen in probate, a process that can take as long as a year. Unlike most other insurance products, though, annuities bear a potentially onerous tax burden when they are liquidated.
Inheritance Tax
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In the United States, only six states -- Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania -- impose a tax on inheritances. If the decedent lived in one of these states at the time of death, any money he left, including annuities, is subject to inheritance tax, which is generally deducted from the amount due to the beneficiary. Each state has its own rules, rates and thresholds, but all exempt spouses from paying inheritance tax. For other beneficiaries, the closer the family relationship to the decedent, the lower the tax rate will be. There is no federal inheritance tax.
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Estate Tax
The federal government imposes an estate tax, as do 12 states and the District of Columbia. For individuals who die in 2015, the federal estate tax is imposed on that portion of the decedent's estate that exceeds $5.43 million -- or double that for married couples. The value of all annuities owned is included in the calculation of the estate for federal and state estate taxes alike. The states that charge an estate tax each have their own rules, rates and thresholds, but all exempt from the estate tax any portion inherited by a decedent's spouse.
Income Tax
Whether or not an inherited annuity is subject to inheritance or estate tax, the beneficiary is liable for income tax. Just like any other qualified account, such as a 401(k) or an individual retirement account, the full value of a qualified annuity, which was purchased with funds on which taxes were deferred, will be subject to income tax.
Unlike other investments, an annuity's cost basis is not recalculated, or "stepped up," as of the decedent's death. Instead, the cost basis remains what the decedent paid for it.
For a nonqualified annuity, though, income tax is only due on the annuity's earnings, or that portion of the annuity's value that exceeds what was originally paid for it. Any amounts subject to income tax are treated as ordinary income. Taxes are due on the funds when you receive them, whether you liquidate the entire annuity, make a partial withdrawal or receive regular periodic payments.