Annuity Death Benefit Tax Implications
If you’ve ever dreamed of winning the lottery, you’ve probably heard of an annuity. It’s a sum of money paid out over many years. But Mega Millions tickets aren’t the only way to get an annuity. You can sign a contract with an insurance company that will issue you an annual payout in the form of an annuity. These can be seen in products like long-term care insurance and lifetime income protection. But if the owner of an annuity dies, what happens to that annuity depends on how it was set up. If the proceeds pass to the estate of the deceased person, though, there may be some tax implications.
Taxability of Annuity Death Benefit
Most annuities have some sort of death benefit, which means that at least one survivor will take it over. But if you have an annuity, you’re likely worried about annuity taxation at death, since your own loved ones will be the ones to pay those taxes. Whether you’re taxed on the amount depends on who takes over the annuity, and you set that up when you work with the life insurance company to write the contract.
The problem with an annuity, though, is that survivors often have a limited amount of time in which to make any decisions regarding annuity distributions after death. It can already be a stressful, emotionally fraught time, making this one more complication. If the survivor receiving your annuity is a spouse or child, it might be worth including verbiage in your will directing how distributions should be handled, or at least having a discussion with your spouse about the best course of action to take.
Taxability of Annuities
Before you can unpack the details of annuity taxation at death, it’s important to first understand how annuities are taxed. One of the biggest benefits of annuities is that the funds grow tax-free until you’re ready to take them out. If you earn any interest or dividends, you must reinvest them in the annuity to keep those tax benefits, but you’ll be able to enjoy tax-free growth throughout the life of your annuity.
When you’re signing your annuity contract, you likely aren’t thinking about how much the tax man will take when you finally begin enjoying the payouts of your investment. As long as you’re not taking distributions from your annuity, you won’t be taxed. But with the first payment, your taxability begins. Annuity payments are taxed as ordinary income, so it will depend on your total income for the year and your tax bracket.
Spouse Annuity Takeover
If your annuity contract designates that it goes to your spouse, there will be no immediate tax consequences. In this scenario, your spouse would simply reassign the annuity to his own name. The annuity would continue to operate as it did when you were alive, only going to your spouse instead of you. But your spouse can also pick the option to take the money in a lump sum.
With the lump sum option, though, if your annuity was held outside an IRA, that distribution will be subject to tax. The IRS will look at the appreciation from the time you took the annuity and the time it was taken out by your spouse, then tax that amount as ordinary income. Instead of taking it all at once, your spouse could also set distributions up gradually, over a five-year period. This means that your survivor will only pay tax on the part taken out each year, making it an easier bill than if he’d taken it all at once.
Non-Spouse Annuity Distribution
Spouses aren’t the only ones who can receive an annuity death benefit. You can choose for your annuity to go to a parent, child or even a friend after your death, as long as you build it into your contract. Unlike your spouse, these other parties can’t simply roll the annuity over to them and continue to take it, though, since they weren’t married to you.
But your non-spouse survivors do have two of the options available to your spouse. They can take the annuity in a lump sum, at which point they would be required to pay taxes on the appreciation as ordinary income. Instead of that lump sum, though, they can choose to take it over a five-year period, which will avoid the hefty tax, plus keep them from moving into a higher tax bracket. Whether the math works out as a better choice for the five-year option can vary from one taxpayer to the next, so it’s important that they crunch the numbers.
Joint Life Annuities and Taxability
One option to keep your annuity going long after your death is to set up a joint life annuity. This is usually an option set up by spouses who want to make sure the survivor is taken care of if something should happen. Insurers usually reduce payouts by one-third to one-half, so if you and your spouse are receiving $6,000 and you die, her monthly check could be as low as $2,000.
The exact details of a joint annuity are set by your insurer, so it’s important to clarify all of these before signing the contract. This doesn’t just go for joint annuities. Your insurance company sets the guidelines for payouts to survivors, as well. But if your annuity is through an employer, joint and survivor options are required to be automatic at the time of retirement if you’re married when you enroll in the plan.
Qualified Vs. Non-Qualified Annuities
How annuities are taxed also depends on how they were purchased. This means when figuring your annuity taxation at death, you’ll also need to think about how you put the funds in when you set it up. If you funded your annuity using money you’ve never paid taxes on, it’s considered a qualified annuity, and the IRS will want its share when you take your distribution. A qualified annuity is funded using money from an account like a 401(k) or IRA.
The other type of annuity you’ll likely encounter when signing your contract is a non-qualified annuity. This means you purchased the annuity using money you’ve already paid taxes on, like cash straight out of your bank account. The IRS already took taxes out on that money, so you won’t owe them again when you take your distribution. However, any money your annuity earns while it’s in the account will be taxable as ordinary income.
Death Benefit Riders
If you’re thinking of your survivors when you set your annuity up, there’s another option that could increase the annuity death benefit your survivors get. Death benefit riders allow you to set up extra funds to go to your survivors in the event of your death. This will be set up through the contract you create with your insurer. One way to do this is through a step-up provision, which means the insurer will increase the value on the anniversary date of signing the contract. This can be done on a monthly or annual basis, depending on the policies of your insurance company.
It’s important to note that death benefit riders can be pricey. You’ll pay extra in fees to add this on, and that can increase your cost by as much as 1.15 percent of the annuity’s value. This isn’t charged to you when you set up the policy or in the months that follow. It will be reduced from the overall value of the annuity at the time of payout.
- The Motley Fool: What Are the Tax Consequences to the Annuity Beneficiary?
- Annuity.org: Annuity Taxation
- Annuity.org: Annuity Beneficiaries: Death Benefits & Payout Options
- Survivor: Blood vs. Water - Wikipedia
- All Things Annuity: Qualified vs Non Qualified Annuities
- Good Financial Cents: SEARCH Annuity Rider #3: Death Benefit Rider
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.