How to calculate taxes on an inherited annuity

Paying taxes on an inheritance can be tricky, and that may be especially true if you’re dealing with an inherited annuity. The tax liability changes based on how the annuity was funded, whether it’s part of a retirement plan such as a 401(k) and even what type of retirement plan it is.

Here are some key things to know about inherited annuities and how to calculate taxes on them.

How are inherited annuities taxed?

If the money distributed from an annuity has not been taxed before, it will be subject to tax when you inherit it. Contributions that have already been taxed will not be subject to income tax.

In addition to owing income taxes, you may be hit with the net investment income tax of 3.8 percent on distributions of earnings if you exceed the annual thresholds for that tax. Inherited annuities inside an IRA also have special distribution rules and impose other requirements on heirs, so it’s important to understand those rules if you do inherit an annuity in an IRA.

Here’s how annuities are taxed depending on the type of account.

Qualified annuities

A qualified annuity is one where the owner paid no tax on contributions, and it may be held in a tax-advantaged account such as traditional 401(k), traditional 403(b) or traditional IRA. Each of these accounts is funded with pre-tax money, meaning that taxes have not been paid on it.

Since these accounts are pre-tax and income tax has not been paid on any of the money — neither contributions nor earnings — distributions will be subject to ordinary income tax.

This information will be reported on a 1099-R filed by the annuity company at the end of the year.

Nonqualified annuities

A nonqualified annuity is one that’s been purchased with after-tax cash, and distributions of any contribution are not subject to income tax because tax has already been paid on contributions.

Nonqualified annuities consist of two major types, with the tax treatment depending on the type:

• A regular nonqualified annuity: This type of annuity is purchased with after-tax cash in a regular account. Distributions of contributed money are not subject to income taxes, but any earnings that are distributed are subject to ordinary income tax rates.
• A nonqualified annuity in a Roth account: This type of annuity is purchased in a Roth 401(k), Roth 403(b) or Roth IRA, which are all after-tax retirement accounts. Any normal distribution from these accounts is free of tax on both contributed money and earnings.

In either case, at the end of the year, the annuity company will file a Form 1099-R showing exactly how much, if any, of that tax year’s distribution is taxable.

Annuities can offer many tax advantages, including tax-deferred growth, so it’s important to understand how their best features can work for you.

Inheritance and estate taxes on annuities

Beyond income taxes, an heir may also need to calculate estate and inheritance taxes. Whether an annuity is subject to income taxes is a completely separate matter from whether the estate owes estate tax on its value or whether the heir owes inheritance tax on an annuity.

Estate tax is a tax assessed on the estate itself. Estates of individuals with assets greater than $13.61 million (in 2024) are subject to federal taxes on the amount over that threshold. The rates are progressive and range from 18 percent to 40 percent. Individual states may also levy an estate tax on money distributed from an estate.

In contrast, inheritance taxes are taxes on an individual who receives an inheritance. They’re not assessed on the estate itself but on the heir when the assets are received. The U.S. government does not assess inheritance taxes, though six states do. Rates range as high as 18 percent, though whether the inheritance is taxable depends on its size and your relationship to the giver.

So those inheriting large annuities should pay attention to whether they’re subject to estate taxes and inheritance taxes, beyond just the standard income taxes.

Bottom line

Inherited annuities pose some challenges for those who receive them, but the basic principle to understand is that any distribution is taxable if tax has not been paid on the money before, unless it’s in a Roth account. Heirs should pay attention to potential inheritance and estate taxes, too.

—Bankrate’s Rachel Christian contributed to an update of this story.