How Annuity Death Benefits and Their Payout Options Work

Annuities are powerful products issued by life insurance companies. They help you live well in retirement by providing a guaranteed stream of retirement income.

But what if you die before you receive your total payouts? Who will take care of your family when you’re gone? Annuities can help there, too.

Many annuities include death benefits. Annuity death benefits allow your beneficiaries to inherit your annuity in the event of your death.

This can provide you with peace of mind, knowing that your family will be taken care of. This article explains exactly how annuity death benefits work, including payout options, tax implications, and more.

What Are Annuity Death Benefits?

Annuities are financial instruments that grow your retirement savings tax-deferred and then can provide a steady stream of retirement income.

Some annuity contracts stop annuity payments after the annuitant or owner's death. But one of the reasons annuities are so popular is that they are flexible.

You often have the option to tailor-fit your annuity to your needs. One way to customize an annuity is by adding death benefits.

Death benefits allow you to name one or more beneficiaries to inherit any remaining annuity payments or balances after your death.

This means that you can purchase an annuity and feel confident that your money will go to your spouse, child, or another loved one in the event of your death.

Do All Annuities Have Death Benefits?

Death benefits are not necessarily included in every annuity.

Most insurance companies offer a death benefit option, sometimes called a death benefit rider, but you might have to pay extra for it.

In some cases, the insurer provides a basic death benefit with the annuity but offers you enhanced death benefit options for an extra charge.

At Canvas Annuity, our annuity products come with a built-in death benefit at no extra cost.

Should you pass away while you have a Canvas Annuity contract, the annuity’s accumulated value will pass on to your specified beneficiary.

If your beneficiary is your spouse, they will have the option to continue the contract as if it was their own.

Common Annuity Death Benefit Options

Depending on your annuity contract and insurance company, you may be able to select from a number of death benefit options.

Here are some of the most common options:

Standard Death Benefit

This is the simplest option.

With the standard death benefit, your beneficiary receives the current annuity’s account value, regardless of whether the value of the annuity increased or decreased since it was issued.

The standard death benefit annuity option is available with Canvas’ annuity products. It is the most common option out there, especially for fixed annuities.

Return of Premium

A return of premium death benefit is a common option for certain types of annuities where the annuity’s value could potentially decrease (like fixed indexed and variable annuities).

In this option, the beneficiary receives either the current annuity account value or the initial premium (minus any withdrawals and fees)—whichever is greater.

Stepped-Up Benefit

In the annual step-up benefit, the insurer sets a “high-water mark” at the highest value your account has reached in a given period (say, a year).

The death benefit is calculated as the current account value or the last high-water mark’s value—whichever is greater.

Like the previous option, this is usually offered for variable and fixed indexed annuities that are more volatile and can decrease in value.

Guaranteed Increase

Another common death benefit option is the guaranteed increase. In this option, a certain percentage is automatically added to your initial contract value each year (say, 3%). The death benefit is calculated as the current account value or that initial investment plus the yearly increases—whichever is greater.

Death Benefit Fees and Charges

Some companies charge a fee for adding a death benefit option onto an annuity.

They may also charge fees for choosing a more generous death benefit option.

You may see additional fees for death benefits rolled into a “mortality and expense” (M&E) charge.

Some companies also have surrender charges. Surrender charges are fees the insurance company levies when an annuity holder withdraws from their annuity early (before the surrender period ends).

Some companies levy this fee against annuity beneficiaries when they withdraw money from an inherited annuity.

At Canvas, we don’t charge beneficiaries a surrender fee on the standard death benefit, whether they choose to receive a lump sum or roll the funds into an inherited annuity.

A death benefit provision is included in our annuity products at no extra cost. Your annuity contract will tell you what fees could apply to your particular annuity if your beneficiary inherits it.

So make sure you read your contract carefully to understand all the fees and make sure your agent clearly defines the benefits.

Death Benefit Tax Implications

Many people think annuities grow tax-free, but that's not quite true.

Technically, they grow tax-deferred. And when the money comes out of the account, you have to pay taxes on it.

Regardless of whether the person withdrawing is the annuitant or the beneficiary, the IRS will tax withdrawals as regular income at the normal income tax rate.

But taxation for inherited annuities depends on several factors.

Qualified vs. Non-qualified Annuities

One critical factor is whether the annuity is qualified or non-qualified. A qualified annuity is an annuity you funded with pre-tax dollars.

Because you’ve never paid tax on that money, you or your beneficiary will have to pay taxes when it’s withdrawn. You pay taxes on the entire amount of money withdrawn—both the principal and the earnings.

A non-qualified annuity is an annuity that you purchased with after-tax dollars. Because you’ve already paid taxes on the principal, you don’t have to pay taxes on it again. But you or your beneficiary will have to pay taxes on earnings.

Non-Spousal Beneficiary Payout Options

Another important factor for tax purposes is how beneficiaries choose to receive their payments. Non-spouse beneficiaries typically have two options for receiving annuity payouts: lump-sum distributions or periodic payments.

You can learn more about annuity beneficiary payout options in our guide to inherited annuities.

Lump-sum distributions

The designated beneficiary can choose to receive the annuity’s remaining value as a lump-sum payment.

Choosing a lump-sum payment could significantly increase your beneficiary’s income the year they receive it.

That could push them into a higher tax bracket, making them pay a higher tax rate.

That’s why it’s usually better to spread out payments.

Periodic payments

A beneficiary’s other option is to receive the annuity in periodic or monthly payments.

In this case, spreading out the income could help avoid massive income increases in any single year.

This would help keep your beneficiary in a lower tax bracket.

The 5-year rule for non-IRA annuities and the 10-year rule

However your beneficiary chooses to receive their annuity funds—either as a lump sum or as periodic payments—they must withdraw the funds within a set period of time.

This withdrawal time limit is determined by where your annuity is held. An annuity can either be held within an individual retirement account (IRA), or it can be its own retirement account.

Annuities not held within an IRA must be withdrawn within 5 years of inheritance.

Annuities within an IRA have more time. The Federal SECURE Act allows these beneficiaries 10 years to withdraw all of the funds.

There are some exceptions to the 10-year rule.

For example, minor children, disabled beneficiaries, chronically ill beneficiaries, and individuals who are less than 10 years younger than the annuitant are excluded from this rule.

Also, since the law is new, older annuities are grandfathered into previous rules.

If you need more specific guidance on the tax rules of inherited annuities, speak with a tax or financial advisor.

Talking to a financial professional is especially encouraged if you purchased your annuity before 2020.

Spousal Beneficiaries

In addition to the payout options above, spouses have an extra option: They can roll the annuity over in their name. This is called spousal continuation.

When this happens, the annuity carries on as if the surviving spouse were the original annuity contract owner.

Choosing a Beneficiary

If your annuity has death benefits, it’s always best to name a beneficiary in an annuity contract when you purchase it.

If you don’t, the annuity will still get distributed to your family, but it may have to go through a lengthy and costly probate process.

Specifying a beneficiary makes the process much easier.

Only the annuity owner can designate a beneficiary. Annuity owners can choose anyone to be a beneficiary—even an organization—and can change beneficiaries at any time unless specified otherwise by the contract.

Owners can even choose multiple beneficiaries or specify contingent beneficiaries (people who receive payments only if the primary beneficiary dies before the owner).

Note that minors cannot access an inherited annuity until they reach the age of majority in their state.

Death Benefits Help You Continue Your Legacy

Annuities are great for retirement planning.

After you accumulate money with a deferred annuity, and when you decide you’re ready, you can annuitize the contract.

Annuitization is when you switch your annuity from the accumulation phase to the payout phase.

The insurance company will let you know what payout options are available to you at the time you decide to annuitize.

Annuities can provide a guaranteed income stream in retirement which is why they’re a pillar of many retirement plans.

And the fact that you can pass on your annuity to your loved one makes them a powerful legacy planning tool as well. It's easy to get the most out of annuity death benefits.

Just make sure you select the death benefit option that makes the most sense for your circumstances. And before signing on the dotted line, understand exactly how the death benefits work in your specific contract.

As always, consult a financial planner or insurance agent if you’re not sure.

Looking to diversify your legacy or retirement planning? Consider an annuity.

It could guarantee you a steady stream of income for the rest of your life and then pass on to your loved ones after your death.

Our friendly, licensed, and non-commissioned representatives are ready to help you learn more. Get in touch today.

Citations

1. Ehling, E. H. Jr. & Marmon, R. (2020, March 25). The Impact of the SECURE Act on Qualified and Non-Qualified Annuities. New Jersey Law Journal. Retrieved March 3, 2021.

2. US Government (2019). Setting Every Community Up for Retirement Enhancement (SECURE) Act. Congress.gov. Retrieved March 3, 2021.