If this is a non-qualified (meaning not in a retirement account) then the owner (or annuitant) of the annuity would have purchased the annuity with after tax dollars.
Taxation
Unlike other investments, the named beneficiary of a non-qualified
annuity does not get a step-up in tax basis to the date of death.
However, that doesn't mean you will have to pay taxes on the
full amount. Because the purchaser of the annuity made the investment
with after-tax dollars, only the amount attributable to investment
income is taxed, but it will be taxed as ordinary income and not enjoy
any special capital gains treatment. When there is a death benefit that
exceeds the value of the account, that additional amount is also taxed
as ordinary income. You will not be subject to the 10 percent
early distribution penalty that applies to distributions before the
annuity owner reaches age 59 1/2.
Distribution Requirements
If the annuitant had begun taking periodic distributions before
death, then you (the beneficiary) must continue the payment option chosen by the
annuitant. For example, if the annuitant chose a life and 15-year period
certain annuity and died after 10 years, you would receive
the same benefit the annuitant was receiving for five more years. If
payment had not begun, a non-spouse beneficiary has three choices: a
lump-sum distribution within one year of the annuitant's death, full
distribution within five years of the annuitant's death or periodic
distributions based on the life expectancy of the beneficiary.
Calculating the Taxable Portion
For periodic payments, a portion of each payment will be considered a
recovery of investment and, consequently, not taxable. This is called
the exclusion ratio. For annuities with variable income, the exclusion
ratio is the amount of the original investment divided over the expected
payments. For a fixed annuity, the exclusion ratio is the ratio of
investment to expected return. If annuity payments already had started
to the deceased, then the beneficiary would have the same exclusion
ratio as the deceased had. However, if the policy calls for a lump-sum
death benefit, then the beneficiary would exclude from that lump sum the
remaining exclusion that the original annuitant hadn't recovered.
Spouse Beneficiary
Again, as with an IRA, spouse beneficiaries often have an additional
option. If the policy has a provision, spouses can take over the annuity
of a deceased spouse. In this case, the spouse would not have to take
an immediate distribution. Because no required minimum distribution rule
exists for nonqualified annuities, the spouse would not have to make
withdrawals at any point. When the annuity includes a death benefit, the
spouse beneficiary usually has to choose an option. One drawback is
that a spouse who takes over a deceased spouse's annuity would then be
subject to the 10 percent early distribution penalty if she needed to
take distributions from the inherited annuity before she reached age 59
1/2, and for early distributions, the taxable portion is removed first.
