Are Annuity Death Benefits Taxable?

When an annuity owner dies, the person or people identified as beneficiaries receive the annuity balance and must pay taxes on that amount. This so-called “inherited annuity” is the outcome of an annuity that has a death benefit provision. So, when beneficiaries inherit annuities and cash them out, they must pay taxes on the current value.

But the timing and type of taxes are determined by the way the beneficiary chooses to receive money and the type of annuity.

Let's review in detail how death benefits from annuity contracts are taxed. That way, you can make an informed choice with your inherited annuity!

What Happens to an Annuity When the Annuitant or Owner Dies?

First, it’s important to note that some annuities are annuitant driven and some are owner driven. The main difference is whose death triggers the death benefit. If the policy is annuitant driven, proceeds are payable to the beneficiary when the annuitant dies. If the policy is owner driven, proceeds are payable to the beneficiary when the owner dies. For the purposes of this article we will stick to discussing deferred annuities that are owner driven.

All annuities allow the owner to name a beneficiary to receive proceeds from the annuity contract upon death of the owner. Depending on the contract, the beneficiary may receive the policies accumulation value, they may receive the accumulation value less surrender charges (if the annuity is still in a surrender charge period), or they may be able to take the accumulation value and open an inherited annuity, which would allow the beneficiary to defer taxes over a longer period of time (more on this below).

When an annuity is purchased, annuity owners work with their agent and insurance company to ensure they have chosen payout and beneficiary options best suited for them.

Income Tax and Annuities

Once the money is inside of an annuity, it grows tax-deferred. That means the owner does not have to pay taxes on the growing account balance. After a set number of years, the policy can be annuitized, which turns the annuity into a steady income stream, payable to the annuitant. At that time the annuitant must begin paying taxes on earnings, as well as any other untaxed portions.

A typical rule for annuities is last-in, first-out. This means the IRS determines that the untaxed part comes out first when you make a withdrawal. When you inherit an annuity, you assume what is referred to as the owner's basis. And you have the same amount of annuity income as the annuitant would have had.

How the annuity was funded affects your death benefit tax implications as well. It depends on whether the owner purchased the annuity with qualified or non-qualified funds.

Inherited Qualified Annuity Taxes

With qualified annuities, the initial funding comes from pre-tax money. This means that, so far, the owner has paid no taxes.

As annuity values grow within these qualified accounts, they do so without the owner paying taxes on the gains. All of the money within the account is sheltered from income taxes while still in the account. But if you inherit a qualified annuity and withdraw the money, taxes will be due.

Since the owner didn't pay taxes on any of the money, the IRS views all death benefit withdrawals as income. They are subject to ordinary income tax rates. So be prepared to pay taxes on the entire withdrawal.

The government also requires you to take distributions from the annuity, per required minimum distribution (RMD) rules.

How Much Tax Do You Pay on an Inherited Annuity?

For any type of annuity, the Internal Revenue Service will require taxes to be paid by the beneficiary either on the lump sum received or on the regular fixed payments. The payments received from an annuity are treated as ordinary income, which could be as high as a 37% marginal tax rate depending on your tax bracket.

The good news is that the beneficiary of an inherited annuity can defer tax impacts by opening up an inherited annuity with an insurance company. You may be able to do this with the same company the original annuity was with or you can look around for better contract terms and open it somewhere else. You can also learn more about annuity taxation at death in our guide to inherited annuities and you can learn more about how annuities are taxed in general here.

If a Spouse Inherits an Annuity

Often, the annuity owner is also the annuitant and names their spouse as the beneficiary.

Suppose the annuity owner dies before annuity payments begin. In that case, the surviving spouse can continue the contract as the owner, but only if the spouse is a joint owner or the sole beneficiary. This is called spousal continuation.

After a change in ownership, the contract continues as if the surviving spouse owned the original contract. This allows the annuity to keep its valuable tax-deferred status and the beneficiary owes no immediate taxes. They will still have the payment options that were stated in the original contract.

The lowest tax exposure option is for the surviving spouse to receive the death benefits over their life expectancy. However, the spouse could also choose to take the money in an immediate lump sum. With the lump sum, the beneficiary-spouse will owe taxes on the entire difference between what the owner paid for the annuity and the amount represented by the death benefit (the increase in value). A lump-sum distribution is an option with the highest tax consequences for the surviving spouse.

Since the spouse has all of the options available to the original owner, they can choose to surrender the contract in the future or annuitize the contract and receive periodic income payments for a set period of time or for the rest of their life. These options will carry with them different tax implications.

If Someone Besides the Spouse is the Beneficiary

The SECURE Act went into effect on January 1, 2020. It stipulates that if you inherit an individual retirement account (IRA) as a non-spouse beneficiary, you generally have 10 years after the annuitant's death to withdraw all the money (known as the 10-year rule). This rule applies to annuities held inside of IRAs, both Traditional and Roth varieties.

Distributions from annuities are taxed as ordinary income. If you don't withdraw everything within 10 years, you'll face a 50% penalty on any money remaining in the account. There are exceptions. This rule doesn't apply to the account holder's spouse or minor children. Non-spouse beneficiaries who are disabled or chronically ill are also exempt from the rule. Further exemptions include beneficiaries who are within 10 years of the age of the original account holder.

The 10 year rule only applies to annuities that are also IRAs. For all other inherited annuities, the five year rule applies. The five year rule states that the funds must be withdrawn (and taxes must be paid on any untaxed portion) within 5 years of the beneficiary inheriting the annuity.

There is one other option for non-spouse beneficiaries of non-qualified funds and that is called the non-qualified stretch annuity. This option is not offered by all insurance companies but if offered, payments will be determined by the beneficiary’s life expectancy and spread out over that time. This provides less income for the beneficiary in any given year, but has the benefit of lower taxes since the income is less likely to push the beneficiary into a higher tax bracket.

How Death Benefits are Paid

There are a handful of ways that annuity death benefits are paid. In all cases, the recipient pays ordinary income tax on the money distributed to them:

A Lump-Sum Distribution: A lump-sum distribution allows the beneficiary to receive the entire remaining value of the contract in one payment.

A "Non-qualified-Stretch" Provision: When a non-qualified stretch provision is included in the contract, the beneficiary receives payments based on his or her life expectancy.

The Five-Year Rule: The five-year rule allows non-spouse beneficiaries of annuities that are not held in IRAs to withdraw incremental amounts during a five-year period or withdraw the entire sum in the fifth year.

The 10-Year Rule: As we mentioned above, for non-spouse beneficiaries of IRAs, the SECURE Act now allows up to 10 years to withdraw all of the money from the death benefit.

Tax Rules When an Annuity Has Been "Annuitized"

If you die after payments have begun as part of annuitizing your contract, the policy will terminate unless you have a death benefit provision in the original contract.

The other option is to choose a "period certain" option that ensures that a beneficiary continues to receive a stream of payments after the annuitant's death for a period stipulated in the contract. If the period has passed, the beneficiary will not receive any additional payments.

Rules for Annuities Prior to Annuitization

If your annuity is in the "accumulation" phase, meaning not yet annuitized, there are specific rules for what happens when you die and have identified beneficiaries to receive the proceeds of our annuity:

Inherited Non-Qualified Annuity Taxes

With non-qualified annuities, funds come from post-tax dollars. This means the money was already taxed before it entered the annuity. Because the annuity owner invested after-tax dollars, the principal isn't taxed when distributed as a death benefit.

Therefore, beneficiaries will only pay taxes on the earnings. Earnings are taxed as ordinary income and don't receive any special capital gains treatment. In this sense, taxes on earnings are like taxes on 401(k)s, traditional IRAs, and other qualified retirement plans.

There is no 10% early withdrawal penalty to worry about with non-qualified annuities. Additionally, RMDs aren't required for this type of annuity.

Inherited Qualified Annuities

With qualified annuities, the initial funding comes from pre-tax money. This means that, so far, the owner has paid no taxes.

As annuity values grow within these qualified accounts, they do so without anyone paying taxes on the gains. All of the money within the account is sheltered from income taxes while still in the account. But if you inherit a qualified annuity and withdraw the money, taxes will be due. Since the owner didn't pay taxes on any of the money, the IRS views all death benefit withdrawals as income. They are subject to ordinary income tax rates.

So be prepared to pay taxes on the entire withdrawal. The government also requires you to take distributions from the annuity, per the required minimum distribution (RMD) rules.

Death Benefit Riders

Some types of annuities offer a guaranteed death benefit to the beneficiary, no matter the amount remaining in the contract. This is known as a death benefit rider, and the annuity owner pays an annual fee for this benefit. Death benefit riders protect beneficiaries against declines in contract values because of market conditions. This type of rider is usually found on a variable annuity.

There are many specific forms of each type of rider, and costs vary. They incur an annual charge either monthly, quarterly, biannually, or annually.

Some living benefits guarantee the account holder's principal. Others guarantee a certain growth rate as long as specific conditions are met.

Review of Death Benefits by Type of Annuity

Death benefits impact the total amount of money available for beneficiaries. The type of annuity (immediate or deferred; fixed, fixed indexed, or variable) determines how much the insurance company pays the beneficiary.

There are general guidelines for determining the benefits of fixed and variable annuities. For fixed annuities, the beneficiary receives the present value of payments. For most variable annuities, the beneficiary receives at least the initial deposited amount.

But the rules still vary. For example, the insurance company keeps the money when the annuitant dies with the lifetime immediate income annuity without term certain. However, the buyer can choose a refund option or period certain rider, where the beneficiary would receive any remaining payments.

For deferred annuities, the amount paid depends on whether the annuity is in the accumulation phase or the payout phase. Annuities in the accumulation phase pay beneficiaries the total amount contributed to the account. Once the annuity is in the payout phase, the beneficiary does not receive payments already made to the annuitant.

Final Thoughts

Understanding the tax rules regarding annuity contract beneficiaries is critical. Annuity buyers should address any concerns about death benefit provisions and beneficiaries when they purchase the annuity.

When you are ready to consider annuities as part of your retirement puzzle, check out Canvas Annuity. At Canvas, our annuities provide steady, guaranteed growth for the annuity term you select. And we allow everyone to select up to five beneficiaries in case they pass away during the contract term. Plus, you don’t need to pay for a death benefit rider. If you pass away during the accumulation phase, the entire accumulation value of your annuity will be paid to your beneficiary. No surrender charges, no making your beneficiary wait until the original contract term is over to get their money. Plus, because we don’t have commissioned agents, we can offer some of the highest interest rates around! If you have any questions, talk to our non-commissioned reps today and see how much your money can grow.