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. Death benefits are taxed as normal income.
A qualified annuity resides in an employer retirement plan or an individual retirement account. When the owner dies, a surviving spouse can roll the annuity and any death benefit into her own IRA and postpone withdrawals until she reaches age 70 1/2. If you inherit a qualified annuity as a non-spouse beneficiary, you can roll it tax-free into an “inherited IRA,” which you establish in the name of the annuity owner for your benefit. You then withdraw the death benefit in annual installments for the number of years allowed under Internal Revenue Service rules. You pay taxes only on the amount you withdraw each year, so you can stretch out your tax payments over the distribution period.
A nonqualified annuity isn’t sheltered by an IRA or employer plan. It resides in a taxable account, and any death benefit is taxable as ordinary income to the extent it exceeds the cost basis of the contract. The cost basis is the amount that the owner paid into the annuity less any portion of the cost already paid out. The contract might allow the beneficiary to convert the death benefit payment into an annuity. IRS Publication 939 describes the General Rule for calculating the taxable percentage of these annuity payments.
One tax disadvantage of nonqualified annuities is that they do not offer a step-up of the death benefit amount. A step-up is an increase in the cost basis of inherited property to reflect its cost basis as of the date of the owner’s death. For example, a mutual fund owner might have contributed $90,000 to the fund during her life. When she dies, the fund might be worth $200,000. If you inherit the mutual fund, your cost basis becomes $200,000, which means you could immediately sell it tax-free. If the mutual fund resided inside an annuity, your cost basis on inheriting it as a death benefit would be $90,000, and you’d owe taxes on the remaining $110,000. Furthermore, the taxes on the annuity are at your normal rates. If you inherit and hold a mutual fund, any profit resulting from its sale after one year is taxed at the lower, long-term capital gain rates.
Death Benefit Riders
An annuity owner might purchase enhanced death benefit riders that increase the size of the benefit to beneficiaries. Naturally, this also increases the amount of tax that beneficiaries will have to pay. Insurance companies offer many different types of death benefit riders. For example, the rider may guarantee a payout equal to the highest value attained by the investments in a variable annuity during the life of the owner. Enhanced death benefit riders cost extra, and this additional cost can reduce the amount available in the death benefit.
- Internal Revenue Service: Publication 590: Individual Retirement Arrangements (IRAs)
- Internal Revenue Service: Publication 575: Pension and Annuity Income
- Internal Revenue Service: Publication 939: General Rule for Pensions and Annuities
- Edward Jones: Annuity Taxation
- Forbes: Living And Death Benefit Riders: How Do They Work?
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