You are grateful for the gifts left to you by a deceased loved one, but if one of those gifts is an annuity, you might find yourself at a loss about how to handle it. Your options vary depending on your relationship to the deceased person, the type of annuity, and your financial goals. Here are some basics to help you out.

Understand What Kind of Annuity You’ve Inherited

First, understand the general definition of an annuity. CNN gives a basic summary of how an annuity works: “…you make an investment in the annuity, and it then makes payments to you on a future date or series of dates.” There are different types of annuities, and things get more complicated when you inherit one as opposed to investing in one of your own. Take time to understand the specifics of the annuity before you make any decisions about it.

Budgeting explains the difference between the two types of annuity you may have inherited. You might have a tax-sheltered annuity or a non-qualified annuity. As stated on the website, a tax-sheltered annuity is “a retirement plan offered by public employers, such as public school districts. It works much like a traditional retirement account…” The employee made contributions over time, and the account grew as a tax-deferred investment. Distribution payments get taxed as ordinary income.

A non-qualified annuity is an annuity that the deceased person purchased on their own. You don’t have to worry about paying taxes on the invested money, since it was already taxed. You will, however, still owe taxes on anything that’s considered investment income (the gains of the annuity).

Learn About Options for the Surviving Spouse and Others

Image via Flickr by 401(K) 2012

If your spouse left you the annuity, you have several options open to you. You can treat the annuity as your own, retaining the same options that belonged to the original owner. If your choice is simply to continue the annuity, it minimizes the tax consequences. The options open to a non-spousal beneficiary are also open to you.

A non-spousal beneficiary has three basic options:

• Accept a lump sum payment. This means that you must pay all owed taxes in a single year. The taxes owed amount to the same as with any other ordinary income, meaning you might have to pay as much as 35%.

• Choose a five-year distribution. Chip away at the taxes owed as you take regular payments from the annuity. At first you must pay taxes on each payment that you receive from the annuity. However, with a non-qualified annuity, taxes were already paid on the original investment, so once you’ve received all the investment income, you don’t have to worry about paying taxes on anything after that. A five-year distribution is not an option for a tax-sheltered annuity. Equity-indexed annuity guarantees don’t experience volatility and you won’t experience a negative return, regardless of if the market took a dive that year or not.

• Spread it out over your lifetime. With a non-qualified annuity, you must opt for this within 60 days. A part of each payment received is taxable. With a tax-sheltered annuity, you can set up an IRA so you receive payments over your lifetime. In this case, since taxes were not paid on the original investment, the entirety of each payment is taxable.

Consider More Than Just Taxes

Certainly, staying on the good side of the IRS while maximizing benefit to yourself is a prime consideration when handling an inherited annuity. There is more that you need to take into account, however. If the person you inherited the non-qualified annuity from died after the annuity start date, you are required to take the distributions at the same rate or a higher rate than did the deceased person. This usually isn’t a big deal, since you can still go for the five-year option or a lump sum.

There is also the question of what to do with your inheritance. If you’re already past the age of retirement, annuity payments can act as a great supplement to your income. Younger people who inherit an annuity should seriously consider investing the money in their future. Taking the time to speak with an investment advisor can help you make decisions that you can feel good about decades down the road.

Dealing with the death of a loved one is stressful enough with having to sift through complicated financial issues. It is vital that you take your time, fully understand the situation, and make decisions based on your financial goals.