01 Sep Are annuities taxed as an inheritance?

Q. How are annuities taxed as an inheritance? Is there a difference if I inherit it directly or if it goes to a trust for which I’m the beneficiary?
— Planning ahead

A. This is a great question, but it’s the kind you should take to an estate planning attorney who knows the details of your situation. That’s because with your question, there are many unknowns.

For example, what is the relationship between the deceased owner of the annuity and you, the beneficiary? What type of annuity is this? Are you inquiring about income, estate or inheritance taxes? Then we have your curveball question about whether the result is any different if the inheritance is through a trust or outright.

What seems like such a straightforward question is anything but that, said Gary Botwinick, an estate planning attorney and chair of the taxation/trusts and estates department at Einhorn Harris in Denville.

Let’s start with the New Jersey and federal estate tax consequences of inheriting an annuity. We’ll assume the annuity is a non-qualified annuity, which means it’s not part of an IRA or other qualified retirement plan.

Botwinick said this annuity would be added to the taxable estate for New Jersey and federal estate tax purposes at its date of death value.

He said an estate will only be subject to New Jersey estate tax in 2017 if the total value of the estate that passes to individuals other than a U.S. citizen spouse exceeds $2 million. This is known as the exemption.

Any amount passing to a U.S. citizen spouse will be completely exempt from New Jersey estate taxes, and if the owner of the annuity lives to the end of 2017, then there will be no New Jersey estate tax on any amount because the estate tax is scheduled for repeal starting on Jan. 1, 2018, he said.

Then there are federal estate taxes. The current exemption is $5.49 million, and Botwinick said this tax is probably not going away in 2018 unless there is some major tax reform in a real hurry.

Like New Jersey, federal estate tax law provides a full exemption to amounts passing to surviving U.S. citizen spouses, he said.

Next, New Jersey’s inheritance tax.

Though the New Jersey estate tax is scheduled to be repealed in 2018, there is no repeal scheduled for the New Jersey inheritance tax, Botwinick said. There is no federal inheritance tax.

The state tax is on transfers to everyone other than a certain class of people, he said.

Class A individuals are completely exempt from the tax. These include spouses, children, grandchildren, parent and step-children.

“The New Jersey inheritance tax applies to annuities just as it applies to other assets,” he said. “Though life insurance payable to a specific beneficiary is exempt from New Jersey’s inheritance tax, the exemption does not apply to annuities.”

Now, income taxes.

Again, we’re assuming this annuity is a non-qualified annuity.

Botwinick said in this case, New Jersey tracks the federal law.

“Beneficiaries of an annuity at an owner’s death are generally taxed in the same way as the owner would’ve been taxed on payout,” he said. “In a nutshell, the proceeds are taxed as they are paid out. A portion of the payout will be treated as a nontaxable return of investment, and the earnings will be taxed as ordinary income.”

Unlike inheriting other assets, Botwinick said, there is no stepped-up basis for inherited annuities. However, if estate taxes are paid as a result of the inclusion of the annuity in the taxable estate, the beneficiary may be entitled to a deduction for inherited income in respect of a decedent, he said.

Finally, you ask whether the result would be different if the inheritance is through a trust.

“Depending upon the relationship between the owner of the annuity and the beneficiary of the trust, there could be implications for both federal and New Jersey estate and inheritance taxes,” Botwinick said. “In particular, the exemption for inheritances by a surviving spouse are very specific, and if a trust is not properly designed, the exemption could easily be lost.”

That’s why, he said, it’s imperative that a qualified attorney design the trust and the overall plan to ensure the most efficient tax treatment.

Ready to see that estate planning attorney now?

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This post was originally published in September 2017.