Understanding the Death Benefits of Annuities
A common feature on annuities is a death benefit that is passed on to your beneficiaries at your death. The amount your heirs receive will depend on the type of annuity you own and which death benefit option you select.
If you purchased an immediate life only annuity, your payments stop at your death and there is no death benefit for your beneficiaries. An immediate annuity that only pays for a fixed number of years, for example 10 years, will payout for those years. Therefore, if the annuitant dies after five years, his or her heirs will receive another five years worth or payments.
If you purchased an immediate life annuity with a Period Certain option, the contract guarantees a minimum number of income payments. For example, a 5-year Period Certain annuity will guarantee a minimum of five years worth of payments. So if you were to pass away two years into the contract, your designated beneficiaries would continue to receive payments for three additional years.
Sometimes you can set up a SPIA to provide an income stream for you and your heirs following your death. For example, a 70-year-old could buy a SPIA structured as a 30-year Period Certain. That means it will pay a minimum guaranteed 30-year income stream regardless of how long the annuitant lives. If the person lives to 102, the person will receive guaranteed lifetime income. If the person dies at age 85, his or her heirs will continue to receive another 15 years of income. Keep in mind that the longer a period certain an annuity has, the lower the income payouts from the contract.
Deferred annuities offer different death benefit options:
A standard death benefit is the annuity value at the time the beneficiary makes a claim. This option typically does not require extra fees.
A return of premium option guarantees your beneficiaries will receive an amount equal to your initial premium, regardless of when you pass away. At the time of death your beneficiaries will receive the larger of the contract’s current value or the amount of contributions made to the annuity. This option usually requires an extra fee.
A stepped up death benefit provides beneficiaries an amount equal to the highest contract value recorded on each contract anniversary. This type of death benefit is most common on variable annuities where the account value can fluctuate.
Many annuities offer death benefit riders for an additional fee. The rider’s death benefit will grow at an annual rate. For example, a rider might increase its death benefit amount 6 percent compounded annually. Other riders may increase in value by a set interest rate each year without compounding, called a simple interest rate. So if the death benefit amount started at $100,000 and grew at a 7 percent simple interest rate, the rider benefit would add $7,000 every year. Many times, this benefit will only increase in value until a certain age or time period, say, 10 years.
Some new death benefit riders provide a “stacking” option that combines a guaranteed annual increase in the death benefit amount with the growth credited to the annuity contract. This is typically offered on indexed annuities where the death benefit amount might increase 3 percent guaranteed and be combined with whatever indexed interest growth the annuity credited.
Tax implications of annuity death benefits
In most cases, annuity death benefits are taxable income. If you are the beneficiary of an annuity, you might receive a single-sum distribution when the annuity owner dies. The amount of this death benefit might be the current cash value of the annuity or some other amount based upon contract riders that the owner purchased. The tax on death benefits depends on a number of factors and are taxed as normal income.
If the annuity was inside of a qualified retirement plan — like a 401(k) or IRA — a surviving spouse can roll the annuity’s death benefit into another IRA. If a non-spouse beneficiary inherits a qualified annuity, it can be rolled tax-free into an inherited IRA, which is established in the name of the annuity owner for the beneficiary’s benefit. The beneficiary can then withdraw the death benefit in annual installments, paying taxes on the amount withdrawn. This allows tax payments to be spread out over several years.
Death benefits of nonqualified accounts are taxed as ordinary income to the extent the amount exceeds the cost basis of the contract. You may also be allowed to convert the death benefit into another annuity.
One tax disadvantage of nonqualified annuities is they do not offer a step-up of the death benefit amount. A step-up increases the cost basis of inherited property to what it was at the date of the owner’s death. This means you can turn around and sell an inherited asset tax-free.
For example, if you inherit a mutual fund worth $200,000 that had a cost basis of $100,000 for the original owner, you can sell it immediately for $200,000 and not owe tax on the sale.
An annuity does not offer this benefit. Under the same scenario, the beneficiary’s cost basis is $100,000, the same as the original owner’s. Furthermore, instead of any gain being taxed at the capital gains rate, the annuity death benefit is taxed as ordinary income.