Tax payment on annuity payout.

July 23, 2015 6:18 AM

I recently received some money (less than $50K) from an annuity held by my late mother. No taxes were withheld at the time. I'm pretty sure I need to pay income tax on this money -- do I need to pay it now, as an estimated tax? (This is in the U.S.) I seem to recall reading that if I wait until next April I may be subject to some kind of penalty. What I think I need are links to info -- I'm not readily finding what I want to know at the IRS website.
posted by JanetLand to Work & Money (7 answers total)

I am not a lawyer or a tax expert, but I did inherit an annuity from my mom. My understanding is that the annuity should be part of her estate, and estate tax is only paid on the amount that exceeds 5 million. If her estate, before being divided with other beneficiaries, was smaller than 5 mil, then there should be no tax, if I understand it correctly.
posted by puddledork at 6:35 AM on July 23, 2015

It may be that whoever was responsible for cutting you the check (i.e. the company that the annuity was from) could give you a ballpark answer on this. I dealt with a bunch of this stuff when my dad passed away and the answer in my case was usually "Hang on to the paperwork and deal with it at normal tax time" This page from Edward Jones seems to back this up.

At your death, the death benefit will be paid to the non-spousal beneficiaries you have designated. By doing so, the transfer will avoid probate (emphasis mine, this may not be part of the estate). Unlike most other securities, there is no step-up in cost basis at your death. Instead, any deferred income in the policy will be taxable to the beneficiaries as ordinary income at their tax rates. If a death benefit is paid out that is higher than the account value, the difference between the death benefit and the amount you invested, adjusted for any withdrawals, will be taxable as ordinary income to the beneficiaries. The value of the variable annuity policy also will be included in your estate for estate tax purposes. Beneficiaries have the choice of taking a lump sum payment or receiving the payments over a period of time, thereby spreading out the income tax liability.

Other information on the odd way annuity income is taxed

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. Beneficiaries are not subject to the 10 percent early distribution penalty that applies to distributions before the annuity owner reaches age 59 1/2.

This is the relevant page from the IRS. Basically, it's complex how the taxes work but it does not look like, in any of the scenarios they outline, that taxes would be payable any sooner than tax time. My suggestion is get a tax professional to do your taxes next year and set aside some of this money to pay them if possible and it will be well worth the money you invest.
posted by jessamyn at 6:39 AM on July 23, 2015 [1 favorite]

There is a penalty for underpayment of estimated tax. The easiest way to ensure this will not be imposed is to remit/withhold 90% of your prior year tax liability. Look your 2014 Form 1040 line 56 (income tax, after credits), multiply by 90%. Assuming you have withholding through a regular W-2 job, you can estimate the amount you'll have withheld (in federal income tax, not payroll or state tax) by looking at your paystubs (note that withholding is calculated on a per-paycheck basis, so if you have multiple jobs or fluctuating income, this gets difficult). Is the amount of estimated withholding for the year at least equal to the 90% of prior year tax? If yes, great! If no, you may want to remit estimated tax payments and/or adjust your W-4 to have more withheld from each paycheck. The 90% thing does not apply if the amount on line 56 was zero.

Most states have a similar penalty.

I recommend getting in touch with a CPA in your area in the next few months (many are out of the office for all of Aug), so you can plan for the 2015 tax year before the tax year closes [note: a local CPA, not a McTax shop like H&R or Jackson Hewitt]. They can help you figure out the extent to which the annuity is taxable (for federal and state/local purposes) and whether you need to adjust your withholding. Many tax preparers I know will charge a tax planning consultation fee, but credit all or a portion of it to the fee for preparing your taxes, if you end up using them for filing returns with respect to that tax year.
posted by melissasaurus at 7:33 AM on July 23, 2015 [1 favorite]

Let's assume the cash value of the annuity is $100,000 when you inherit it. There is no income tax payable on an inheritance.

Let's assume you receive $5,000 a year in annuity payments. As said by others, that will be partially tax-free (the principal) and partially taxable as ordinary income (the earnings). Normally the insurer will provide you with a variant on form 1099 after the end of the tax year that tells you how much is income and how it is characterized.

Then, if you do not understand it and how to use it, you will want to consult with an accountant. Advance consultation would not be a bad idea (in October or November) but the accountant would only be speaking hypothetically until you get the first 1099.
posted by yclipse at 8:30 AM on July 23, 2015

The easiest way to ensure this will not be imposed is to remit/withhold 90% of your prior year tax liability.

This is not correct and confusing two separate rules. There are two different safe harbor rules. The first safe harbor is if your tax payments are at least 90% of your current year's taxes. This requires figuring out in advance how much you think you will owe. The second safe harbor is if your tax payments are 100% of last year's taxes. (If your income is more than $150,000, then the second rule is 110%.)

For most people, the simplest rule is the second one because it doesn't require you to know this year's taxes. Just make sure that you are paying at least as much tax as you did last year. If your job salary is the same or more than last year and you didn't owe any extra taxes last year, you should be covered for this year by your paycheck withholding. But also note, although you avoid a penalty, that you will probably owe a big extra tax payment next April, so make sure you have cash set aside for that.
posted by JackFlash at 10:40 AM on July 23, 2015

Response by poster: I think I should clarify that this money is no longer in annuity form -- when Mother died the annuity was cashed out and divided three ways. I simply received a check for some money.
posted by JanetLand at 4:19 PM on July 23, 2015

Jackflash: you're so right. I should know better; I was tired and posted too quickly and mucked up the rules.
posted by melissasaurus at 8:41 AM on July 24, 2015