Survivors and Beneficiaries(p81)

Generally, a survivor or beneficiary reports pension or annuity income in the same way the plan participant would have. However, some special rules apply. See Publication 575 for more information.

If you are entitled to receive a survivor annuity on the death of an employee who died before becoming entitled to any annuity payments, you can exclude part of each annuity payment as a tax-free recovery of the employee's investment in the contract. You must figure the taxable and tax-free parts of your annuity payments using the method that applies as if you were the employee.

If you receive benefits as a survivor under a joint and survivor annuity, include those benefits in income in the same way the retiree would have included them in income. If you receive a survivor annuity because of the death of a retiree who had reported the annuity under the Three-Year Rule and recovered all of the cost tax free, your survivor payments are fully taxable.

If the retiree was reporting the annuity payments under the General Rule, you must apply the same exclusion percentage to your initial survivor annuity payment called for in the contract. The resulting tax-free amount will then remain fixed. Any increases in the survivor annuity are fully taxable.

If the retiree was reporting the annuity payments under the Simplified Method, the part of each payment that is tax free is the same as the tax-free amount figured by the retiree at the annuity starting date. This amount remains fixed even if the annuity payments are increased or decreased. See Simplified Method, earlier.

In any case, if the annuity starting date is after 1986, the total exclusion over the years cannot be more than the cost.

If your annuity was a joint and survivor annuity that was included in the decedent's estate, an estate tax may have been paid on it. You can deduct the part of the total estate tax that was based on the annuity. The deceased annuitant must have died after the annuity starting date. (For details, see section 1.691(d)-1 of the regulations.) Deduct it in equal amounts over your remaining life expectancy.

If the decedent died before the annuity starting date of a deferred annuity contract and you receive a death benefit under that contract, the amount you receive (either in a lump sum or as periodic payments) in excess of the decedent's cost is included in your gross income as income in respect of a decedent for which you may be able to claim an estate tax deduction.

You can take the estate tax deduction as an itemized deduction on Schedule A, Form 1040. This deduction is not subject to the 2%-of-adjusted-gross-income limit on miscellaneous deductions. See Publication 559, Survivors, Executors, and Administrators, for more information on the estate tax deduction.