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Annuity Death Benefit; Inherited Annuity FAQ – Annuity Beneficiary Taxes & Payment Options Explained


Annuities often include a ‘death benefit’ as part of their contracts. For consumers, the term ‘death benefit’ may evoke thoughts of life insurance. However, it’s crucial to grasp the distinctions between a death benefit in a formal life insurance policy and one within an annuity contract.

In this post, we’ll delve into the intricacies of annuity death benefits. If you’re beginning to explore this topic, you might want to check out our previous post for a foundational understanding of annuity death benefits.

What is an Annuity Death Benefit?

Annuity Death Benefits are proceeds that a beneficiary/beneficiaries receives from an inherited Annuity Contract. The annuity company distributes the death benefit of the inherited annuity to the designated beneficiary/beneficiaries when the annuitant dies. 


Owner vs. Annuitant

The owner of the annuity will name an annuitant and designate a beneficiary. More often than not, the “owner” of an annuity contract is also the “annuitant” of the contract. Still, it’s noteworthy that contract owners can list someone other than themselves as the annuitant, and beneficiaries can be someone or something. (Examples: Charities, Trusts, Churches, Schools, etc.)

Therefore, understanding the roles of an Annuity Contract Owner vs. an Annuitant will be helpful while you’re in your planning phase.

See below:

Owner and annuitant

Standard Death Benefits by Annuity Type


Standard Death for Immediate Annuities

Immediate Annuities generally have no death benefit, especially if payments have already started and a straight lifetime payment option was selected.

Therefore, the beneficiary/beneficiaries would receive nothing. The insurance company keeps any remaining premiums, regardless of when the payments started, unless a “Cash Refund Rider” is in the contract.

A “Cash Refund Riderrefunds the beneficiary with any remaining premiums (the amount invested into the contract) if the annuitant dies before the total premiums paid have been paid out. The remaining funds are often distributed as a lump sum payment, but some insurance companies may provide additional distribution options.

  • Payments from immediate annuities must begin no later than 12 months from the date of issue.
  • “Premiums” means the amount invested into the contract.

Standard Death for Deferred Annuities

Fixed annuity and fixed index annuity death benefit

There is no additional fee for the standard death benefit in Fixed & Fixed Index Annuities. The standard death benefit in Variable Annuities carries a fee that’s built into the “mortality and expense” fee.

Death Benefit Riders


Guaranteed Minimum Death Benefit (Variable Annuities Only)

Also known as “GMDB,” a “guaranteed minimum death benefit” works very similarly to its cousin GMIB, since it also offers a value separate from the contract value which grows at a guaranteed rate for a certain period of time.

The beneficiary will receive the higher of:

  • The contract value
  • The total premiums paid
  • The enhanced death benefit rider value

Market Step Up Death Benefit Rider (Variable Annuities Only)

Also known as the “Highest Anniversary Value” death benefit. For a certain period of time, the insurance company will track the contract value each annual contract anniversary. If the contract anniversary value is higher than the previous year, it will lock in as a potential death benefit.

The beneficiary will then receive the higher of:

  • The contract value
  • Premiums paid
  • The highest contract anniversary value

Death Benefit Riders for Fixed & Fixed Index Annuities

Fixed products rarely have any enhancements or riders to the death benefit. Oftentimes, the contract value plus prorated interest and fees is the death benefit for Fixed and Fixed Index Annuities.

Some Fixed & Fixed Index Annuity products on the market offer the income benefit base as a potential death benefit if taken over a period of time (usually five years).


Withdrawals reduce the death benefit, and the calculations for the reduction will vary.


Inherited Annuity Beneficiary Payout Options

Are Annuities Taxable to Beneficiaries?

Annuity Beneficiary payout options & taxes on an inherited annuity varies, as it will depend on the tax status of the inherited contract and the beneficiary’s relation to the deceased owner.

Death Benefit From a Qualified Contract

Funds within “qualified” contracts are pre-tax dollars, such as an IRA, Roth IRA, 403b, 401k, etc.

What is the difference between inheriting assets from a qualified annuity contract versus inheriting qualified assets from a traditional investment account?

The payout options.

Payout options will vary based on your relationship (spouse or non-spouse beneficiary) with the deceased contract owner.

Any individual can inherit funds from a qualified account, whether the account is an annuity or not. Example: brokerage account, 401k, IRA, etc.

Inherited Annuity Payout Options for Spouses (Qualified Contracts)

Spouses have the most leeway for Qualified inherited contracts. In addition to having the same payout options as a non-spouse beneficiary, spouses can choose to take ownership of the contract. Meaning they can maintain the tax-deferred status and have the same control over the inherited annuity as the original owner.

Once the spouse is named as the new contract owner, they have the authority to name a new beneficiary, continue any payments that have already started, or even initiate the guaranteed income stream if they haven’t started yet.

Non-Spousal Inherited Annuity Payout Options (Qualified Contracts)

Unless the beneficiary is chronically ill, disabled, is a minor child, or not more than ten years younger than the original owner, non-Spousal Beneficiaries have two options:

  1. Spouses have the option roll the funds over to an inherited IRA, where they can choose to realize required minimum distributions (RMDs) calculated over their lifetime in place of the deceased annuitant’s lifetime.
  2. Take distributions over ten years from the date of death. It doesn’t matter how much is taken each year or if gains are realized every few years. The only requirement is the account must be fully liquidated by December 31st, ten years after the date of death.

Death Benefits from a Non-Qualified Contract

Non-Qualified contracts contain “post-tax” dollars or after-tax dollars, and the growth is tax-deferred until a distribution takes place.

Unlike Qualified accounts, payout options from a Non-Qualified annuity are the same for both spousal and non-spousal beneficiaries.

Payout options vary between insurance companies, see the three standard options below:

Non qualified annuity beneficiary options

Beneficiary Tax Implications to Consider

When an annuity contract is acquired with a specific focus on the death benefit, it becomes imperative to gain a comprehensive understanding of how this benefit is subjected to taxation. This knowledge is pivotal in making informed decisions aligned with your legacy goals.

Death Benefit Tax Implications to Consider for Qualified Accounts

Since funds from a qualified account have never been taxed, any distribution are taxed at the beneficiary’s ordinary income rates. If a beneficiary is under the age of 59.5, then a 10% tax penalty will also apply. Tax implications do not apply for rollovers.

Please note: The 10% tax penalty rule applies to Qualified and Non-Qualified annuity contracts.

Death Benefit Tax Implications to Consider for Non-Qualified Accounts

As mentioned, Non-Qualified contracts contain “after-tax dollars” (also known as the “cost basis”).

Since a portion of the contract value include after-tax dollars, only a portion of the proceeds are taxable.

The “cost basis” is the non-taxable amount within the contract.

Confirming the cost basis with the distributing insurance company and discussing it with your tax advisor will eliminate surprises when it’s time to address the taxes owed on the inherited funds.

Once you’ve confirmed the cost basis, you can subtract the cost basis from the death benefit value to provide a close estimate of the taxable amount.

CAUTION:

I can’t stress this enough: It is imperative not to assume that the original premiums paid into the contract are the same as the cost basis.

It can be, but that is not always the case. For example, the cost basis can differ from the premiums paid into the contract if the contract was a 1035 exchange from a previous annuity contract.

What is a 1035 Exchange?

A 1035 exchange is when an annuity contract owner elects to move the funds from one non-qualified annuity contract to another non-qualified annuity.

The previous insurance company will or at least should provide the new company with the original cost basis, causing the amount of the premiums paid into the new contract to be different from the cost basis.

Therefore, it’s imperative not to assume that the premiums paid into the contract is the cost-basis. Doing so, can cost you an unexpected or, worst, a large tax bill if the contract you inherited turned out to be a 1035 exchange from an old contract.

See below:

Annuity tax sample

Annuity Death Benefit vs. Life Insurance


Although life insurance companies issue annuities, they’re not life insurance policies. In fact, annuities were designed to do the exact opposite of what life insurance policies do.

What is that supposed to mean? Well, annuities protect you if you outlive your assets or, in other words – live too long.

So if you’re still alive & your assets have dwindled, you will still have this income to fall back on, whereas Life insurance policies were designed to protect your loved ones if you unexpectedly pass or, in other words, pass too soon.

If there is a strong probability that you’ll outlive your assets, then an annuity may be a great safety net to have in place for income. On the other hand, if legacy aspirations are your primary concern, then a formal life policy is going to be the most cost-efficient & tax-efficient route to take, here’s why below.

Annuity Death Benefit Disadvantages

  • Cost: I rarely came across death benefits within annuities that were substantially higher than the contract value, making it difficult to justify the death benefit rider fee. For example: Suppose your contract value is $300,000, and your enhanced death benefit has only grown to $350,000. That’s technically an insurance value of $50,000. If your death benefit rider fee is 1% of the death benefit value, that’s an annual fee of $3,000 for a 50k life insurance policy. Depending on the circumstances, premiums for a 50k whole-life policy are often significantly less, and the premium for a term life insurance policy is even lower.

  • Tax Benefits: Death Benefit proceeds from a life insurance policy are not taxable. Gains accrued on a non-qualified annuity are taxed at the beneficiary’s ordinary income rate. So if your grandpa bought his annuity decades ago at $50,000 and it’s grown to $500,000, the beneficiary will be taxed on $450,000 at their ordinary income rates plus an additional 10% if the beneficiary is under age 59.5. 


There is also no “step up” in cost-basis like there is for traditional investment vehicles.

Takeaway

I recognize that there are consumers out there who believes they are “uninsurable” and can’t obtain a formal life policy. However, the good news is that the life insurance industry continues to evolve & has come up with additional Life Insurance products that are more flexible than others. Hence, it’s worth checking or revisiting.

If you and your agent have exhausted life insurance options and determined that an annuity death benefit is in your best interest, that’s fine too. Annuities are an option for life insurance, but it should not be your first stop for it.


What are your thoughts? Were you a beneficiary on an annuity? Share your thoughts and experiences in the comments!


Annuity Death Benefits

Disclaimer: The opinions expressed in this blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security, investment, or insurance product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.


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