Buy a $200,000 Annuity With Savings at 65 and Leave It to the Kids at 85, and About $240,000 of Growth Is Taxed as Their Income. The Same $200,000 in a Brokerage Account Passes to Them With No Tax on the Growth at All

A 65-year-old with $200,000 in savings who wants to leave money to the kids faces a choice that is easy to underestimate. The first path is a nonqualified deferred annuity bought with after-tax savings. The other is an ordinary taxable brokerage account. The hard truth is that both can grow at the same rate for two decades, but the federal tax code treats them almost oppositely at death. That gap can cost heirs tens of thousands of dollars.

How $200,000 Grows Into Roughly $438,000 by Age 85

Let’s assume, for argument’s sake, the money compounds at 4% a year from age 65 to 85. At that pace, the balance reaches about $438,225. That means roughly $238,225 of the final value is growth. The original $200,000 goes back to heirs tax-free either way. This whole comparison comes down to what happens to the growth sitting on top of it.

Annuity Heirs Inherit a Deferred Tax Bill

Federal law handles the money paid into an annuity as the “investment in the contract,” defined as the aggregate amount of premiums or other consideration paid. That portion comes back tax-free. However, the growth has never been taxed. According to IRS Publication 575, annuity earnings “aren’t taxed until distributed” and the taxable part “is treated as ordinary income.”

Death does not erase that untaxed gain. The step-up rule for inherited property specifically does not apply to a right to receive income in respect of a decedent. Under a separate section, that income is taxed to the person who, because of the decedent’s death, acquires the right to receive it. The parent put off the tax for 20 years, and the children end up paying it.

Why the Timing Hurts Adult Children

Heirs usually have to act quickly, and when the owner dies before annuity payments start, federal law generally requires heirs to distribute the entire interest in the contract within 5 years. If the growth is split equally over that window, each heir’s tax return picks up about $47,645 a year in extraordinary income. That money stacks on top of their paychecks, often in their 50s, when they are making the most.

Assume a 24% marginal federal rate. At that rate, the growth produces about $57,174 in federal income tax, before any state tax. Publication 575 also notes that nonqualified annuities count toward your net investment income for the Net Investment Income Tax, which can apply to higher-income heirs.

Brokerage Heirs Start With a Clean Slate

The brokerage account gets very different treatment. Inherited property takes a basis equal to the property’s fair market value on the date of the decedent’s death. A child who inherits an account worth $438,225 gets a cost basis of $438,225. If they sell the next morning, they owe no capital gains tax, and the 20 years of growth are never taxed as anyone’s income.

The timing of the transfer matters. If the parent gives the same shares away while still alive, the child’s basis is the same as the donor’s, so the built-in gain comes with the gift. Holding the shares until death is what triggers the step-up.

Where the Annuity Still Has an Edge

The brokerage account is not tax-free while the owner is alive. Dividends and any gains the owner realizes are taxed each year. Long-term gains get capital gains rates, including 0% and 15% brackets. That annual drag is real, and the annuity owner avoids it for two decades.

Annuities also solve a different problem than estate planning does. Their main job is income you cannot outlive. Once a contract is converted into payments, the tax code excludes part of each check based on the contract’s investment. A retiree who spends the annuity during their lifetime never runs into the inheritance problem. The tax penalty mostly lands on money that sat unused until death.

What a 65-Year-Old Saver Should Weigh Before Choosing

First, sort your savings by purpose. Money you expect to spend on living costs can benefit from an annuity’s deferral and income guarantees. Money you expect to leave behind is generally better off in an account that qualifies for the step-up.

If you already own a deferred annuity you mostly expect to pass on, consider taking gains a little at a time in years when your tax bracket is low. Spreading the income over several lower-income years can cost less than having your children absorb it during five years of peak earnings. Ask a tax professional to run the numbers for you.

Finally, review your contract’s beneficiary designations and death-benefit payout options now, while you can still change them (outdated beneficiary forms and poor ownership are two mistakes we flagged in a free estate checklist). The 4% return used here is an illustration. A higher return means more growth, and more growth widens the gap between the two accounts. For heirs, the key question is whether the gain is taxed as income or wiped out at death.

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