If a spouse inherits the annuity, then they can almost always continue the annuity contract as it is and thus face no immediate tax issues. But there are options, especially for non-spouse heirs.
As the Motley Fool discussed in an article entitled "Tax Rules for an Inherited Non-Qualified Annuity," there are typically three options, including:
- Take a Lump Sum – If an heir chooses a one-time payment, then the heir will need to pay income tax on any appreciated amount over the original premium payments the deceased made.
- Arrange for Smaller Payments Over Time – By accepting smaller period payments, the heir can avoid a large one-time income tax payment. However, income tax will still be owed on any appreciation of the annuity.
- Switch to a Different Annuity – The person who purchases an annuity can switch to a different provider without paying income tax. However, it is unclear if someone who inherits the annuity can do the same. In a private letter ruling the IRS allowed one heir to do so, but many annuity providers do not wish to rely on the ruling as it technically only applies to the person who asked for it. Some providers will work with heirs on switching providers though.
Should you inherit a non-qualified annuity it would most likely be beneficial to meet with an estate planning attorney about your options and the impact of any decisions.
Reference: Motley Fool (Dec. 19, 2015) "Tax Rules for an Inherited Non-Qualified Annuity"