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Building a comfortable nest egg for retirement can take many years. Ideally, every investor would have the opportunity to benefit from those decades of effort, but it doesn't always work out that way. If you die prematurely, your retirement annuity will pay a death benefit to your estate or chosen beneficiaries. Those amounts are taxable at the ordinary rate, and your heirs can choose several ways to manage the resulting tax situation.
Annuities are based on life insurance, and the ability to name beneficiaries is one of their insurance-like characteristics. Your beneficiary can be your spouse or child, any other person, a trust or a charity. If you die prematurely, your annuity's death benefit is paid directly to your beneficiary without going through the time-consuming probate process. If you don't name a beneficiary, or if your beneficiaries die before you, the annuity's death benefit becomes a part of your estate and goes through probate. If you haven't started taking income from your annuity, the death benefit is usually its current value. If you have begun taking income, the death benefit consists of any remaining guaranteed payments, which continue to your beneficiary.
Your beneficiaries have a few options for dealing with the inherited annuity -- and the tax bill it triggers. The simplest option is to take the entire amount as a lump sum. Your heirs will write a hefty check to the IRS, but then have complete freedom to use or reinvest the lump sum as they choose. Your heirs can also choose to receive the funds over a five-year period, breaking the tax burden into smaller annual sums. A final option allows your heirs to take the death benefit in the form of payments for the remainder of their life expectancy, which spreads taxation as thinly as possible.
Unlike any other beneficiary, your surviving spouse has the option of simply assuming ownership of the annuity. The annuity contract remains in force, no taxable event is triggered, and your spouse will eventually receive income payments just as you would have. This is a good option, unless your spouse needs to access the funds and is younger than 59 1/2. Withdrawals below that age are subject to an additional 10 percent tax penalty, so it's sometimes better for your spouse to accept the death benefit as a lump sum. It's still taxed as regular income, but there's no additional penalty to pay.
If you use your annuity to purchase an IRA or 403(b) plan, that makes it a "qualified" annuity and changes how the death benefit is handled. Heirs who opt for lifetime payments have until the end of the following year to make that choice, rather than one year from the date of death. A surviving spouse who's the beneficiary of a qualified annuity has the option of rolling over the annuity's death benefit into an IRA in her own name.
Estate planning is a complicated process, and every investor's situation is unique. Unless you're a skilled estate planner or tax lawyer in your own right, it's usually prudent to seek professional financial advice. A modest amount of advance planning could pay off in substantial tax savings for your heirs. It's also important to discuss the options with your beneficiary, and if necessary to leave written instructions for how best to manage the death benefit.
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