Inherited Annuity

What do you mean by "capital gains"? Do you mean an increase in the price of the mutual fund shares within the VA? Those will not be treated as capital gains. They will be treated as ordinary income (like interest) when they come out of the VA.

I would think all you need to do is gift outright ownership of the VA itself to your son (and his wife). Then the taxable portion of any distributions they take will be taxable to them.

I don't think it works like this Rich. First thing that needs to be done is to understand what options were written into the contract regarding the death of the owner who is not a surviving spouse. Typically, the following options are available to the beneficiary for a variable annuity:

1. Take a lump-sum distribution equal to market value or the death benefit if higher. OR
2. Take a five year deferred annuity based on market value. Any earnings on the assets during the five year period continue to accumulate. OR
3. Annuitize the greater of the market value or death benefit over your expected life or a period of years spelled out in the contract.

The accumulated earnings on the account are taxable as ordinary income to the beneficiary when there is a distribution. Option 1: All taxable when received. Option 2: Taxable amount is amortized over the five year period. Option 3: Taxable amount is amortized over the annuity period.

I seriously doubt that there is an option to gift the annuity to someone else.

The only way I know of for the beneficiary to avoid taxes is to disclaim the inheritance. Then the annuity will go to the estate of the decedent and be distributed to living heirs under state law of the decedent.

As the amount in question is below the annual gift tax exclusion, the OP could just take the money using Option 1, 2 or 3; declare the ordinary income on his tax return and gift the rest to his son and d-i-l. If he elects to annuitize over his life or five years, he could name his son and d-i-l as beneficiaries should he die.

Oh, excellent point.

I was over-reading "inherit". I was reading it as "took possession of the actual instrument from the decedent" rather than "was the named beneficiary of the decendent's contract".

Since the situation is the latter, you are of course correct.

(Out of curiousity, though, what does happen if the measuring life of the annuity is NOT that of the owner -- so that the VA still exists after the owner dies. Or is that a definitional impossibility with an annuity? If it is, then how about a life insurance contract? I know with LI the policy owner does not have to be the insured. So if the policy owner dies while the insured is still alive you then can have a true inheritance, right? In which case the heir could gift the policy away to someone else?)

As to the VA, it has a beneficiary. You die, the beneficiary gets the contracted death benefit. Typically that is either going to be the amount in the account or the guaranteed death benefit amount. As to the life insurance contract.... as far as I know, it is an asset like any other asset subject to probate. It gets passed to an heir based on state law (testate or intestate).

I found this on the internet, so I will toss it into the mix:

Gifting an annuity contract If you make a gift of an annuity you own, special income tax rules apply. If you owned the annuity for some time before making the gift, you are subject to a tax on the difference between the value of the annuity (its cash surrender value) and the amount you have invested in the contract (your premiums). You would have to claim the income in the tax year you make the gift. This rule applies to gifts of annuities to charities and charitable remainder trusts as well. A gift of an annuity contract between spouses generally does not trigger this tax, however.

What you read referred to the original owner not a beneficiary. For contracts issued after 4/22/87 (weird rules for earlier contracts), the donor gets taxed on the built-in gain at ordinary tax rates.

When the owner of a non-qualified annuity dies the annuity comes to an end and the non-spouse beneficiary either takes it all (and gets taxed), uses the five year rule (and gets taxed) or spreads the payments over his/her lifetime and gets taxed. What I failed to realize in my earlier reply is that the taxable amount is not amortized over the life term of the beneficiary. A quick check of the law tells me that the taxable amount is distributed first and then basis gets distributed if the beneficiary amortizes over his/her lifetime.

By the way, this reply and my previous reply assumed that the original owner had not started to take distributions.

So, the net of all this is that the beneficiary is going to get taxed. I suppose the next question is: If the beneficiary elects to receive the annuity over his/her lifetime, does he/she then become an annuity owner who can gift it to someone else? I'm not sure, but no matter what, the beneficiary is going to pay the tax on the ordinary gain.

Lastly, if the original owner had an estate large enough to trigger estate tax, then the beneficiary would be eligible for a tax credit to offset some of the tax due on the annuity gain.