When planning for retirement, annuities can be a go-to tool for providing steady income in your sunset years. But what happens to your annuity funds if you pass before being fully paid or paid at all? As long as you take the necessary steps, many annuities have options for your beneficiaries, allowing for the passing your estate to your loved ones smoothly.
Whether you’re arranging for your assets to be transferred to your next of kin or anticipate inheriting an annuity from a parent or another loved one, it’s imperative to understand the ins and outs of annuity beneficiary rules. This article covers how death benefits work and provides a detailed answer to whether annuity death benefits are taxable.
What’s an annuity beneficiary, and how do annuity death benefits work?
Beneficiaries are the people you choose to receive your annuity’s remaining funds if you die. Most annuities let you name one or more beneficiaries. This means your money can go straight to them without having to go through probate — the legal process of proving a will, paying debts, and distributing out assets. This can make annuities an effective and efficient way to pass on your wealth.
Death benefits specify how much of the remaining funds beneficiaries are entitled to. Depending on the contract, beneficiaries may get a guaranteed amount, a series of payments, or the annuity’s remaining value.
Not all annuity contracts automatically come with death benefits. When planning for your family’s financial future, make sure to check your annuity’s terms to see if a death benefit is included. If not, you can choose a different type of annuity or add a rider to make sure your beneficiaries are provided for.
Who can be named as an annuity beneficiary?
Annuity contracts allow you to name several types of beneficiaries — here are a few options.
Spouse
Spouses are the most common beneficiaries because their finances are usually tied closely with the annuitant’s. They also have the most flexible payout options. For example, a spouse can keep the annuity going in their own name (called spousal continuation and often by being added as an additional annuitant on the contract) or move the money into another retirement account.
Non-spouse
Children, siblings, and friends are examples of non-spouse beneficiaries. Based on the terms of the contract, some recipients may be able to continue annuity payments as planned, while others might need to withdraw the funds within 5–10 years of the annuitant’s death. Rules vary depending on whether the account is qualified or non-qualified.
Multiple beneficiaries
Annuity owners can name more than one beneficiary and decide how to split the money among them. It’s a good idea to clearly list what percentage each person receives to help prevent arguments and legal problems.
Contingent beneficiaries
If the main (primary) beneficiary has died or can’t take the annuity payout, the money goes to the backup choice, called a contingent beneficiary. If there isn’t a contingent beneficiary — or no beneficiaries are still living — the money becomes part of the owner’s estate. It then goes through probate and is handled according to their will and state laws.
What happens to an annuity when the annuitant dies?
How providers handle annuities after death depends on whether the account is in the accumulation or payout phase.
Annuity not yet annuitized (still in accumulation phase)
The accumulation phase is the time when the annuity owner is still making contributions and earning interest. They haven’t started taking payments yet.
If someone inherits the annuity during this phase, they usually get the accumulated amount known as the account or contract value. Some annuities promise a guaranteed minimum death benefit, so the beneficiary in this case would receive a preset amount.
Annuity already in payout phase
When an annuity is in the payout phase, the contract rules determine how insurance providers handle the remaining money after the owner dies. Depending on the annuity type and terms, beneficiaries can choose to withdraw all the money at once (a lump sum) or may be able to receive payments over time.
Taking a lump sum gives them quick access to the money, but it might lead to a bigger tax bill. Getting the money through a series of payments can spread out the income — and the taxes — over several years.
Life only and period certain contracts
Certain situations result in beneficiaries not receiving the whole annuity or any payments at all. These include life only contracts, which end when the annuitant dies, and period certain contracts, which stop payments once the designated timeline ends.
Inheriting an annuity: Tax rules you need to know
When receiving a death benefit, understanding whether an inherited annuity is taxable is vital. Recipients must follow tax rules to avoid an unwelcome visit from the IRS.
Here’s a breakdown of the tax implications for different types of annuities.
Qualified vs. non-qualified annuities
Tax rules affect qualified and non-qualified annuities differently:
- Qualified annuities are funded with pre-tax dollars, so the beneficiary’s entire payout may be taxable as ordinary income, regardless of the distribution method.
- Non-qualified annuity inheritance involves accounts funded with after-tax dollars. The part of the payout that comes from the original investment (the principal) is tax-free. However, any earnings are taxed as ordinary income.
Rolling qualified annuities into other types of retirement accounts can maintain the funds’ tax-deferred status.
Lump-sum vs. periodic payments
Lump-sum payouts can lead to a hefty tax bill, especially if the amount is large enough to push the beneficiary into a higher tax bracket. Any funds that fall above the threshold will be subject to a higher tax rate. Recipients should always weigh their need for money against the tax consequences.
Periodic payments can spread the distributions over several years, which can help minimize the annual tax impact and keep beneficiaries in lower tax brackets.
Stretch option
The stretch option on non-qualified annuities allows certain eligible designated beneficiaries to extend the distribution over their life expectancy. It is important to review the contract and terms of the stretch option if offered. The following people qualify:
- Surviving spouses
- Minor children of the deceased
- Disabled or chronically ill individuals
- Beneficiaries not more than 10 years younger than the deceased
5-year and 10-year rules
The SECURE Act of 2019 introduced the following regulations:
- The 5-year rule generally applies to non-qualified annuities and requires beneficiaries to withdraw the full value of the annuity within five years of the annuitant’s death.
- The 10-year rule requires distribution of the entire inherited amount within 10 years of the annuitant’s death.
Provide for your beneficiaries with Gainbridge’s annuities
Whether you're setting up an annuity or are the beneficiary of one, seeking professional guidance can help you make informed decisions and optimize the financial outcome. With no commissions or hidden fees, Gainbridge’s annuities can help secure your financial future and provide peace of mind for you and your beneficiaries. Visit Gainbridge today to explore how annuities can fit into your financial plan.
This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes.
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