Annuities are retirement investment vehicles offered and maintained by life insurance companies. If you own, or are considering buying an annuity, understanding the potential tax ramifications to your heirs is essential to proper planning. While annuities may provide advantageous features that improve the quality of your retirement lifestyle, most contracts also allow the inclusion of death benefit options not available in other account types.
Death Benefit Provisions
Annuities offer death benefit features not available in other types of retirement accounts. A variety of options are available to anyone concerned with the financial well-being of their heirs, as well as their own future financial security.
Inheriting an annuity creates a potentially significant income tax liability for the beneficiary. Upon the death of the original contract owner, the life insurance carrier will pay the death benefit to the designated recipient in one of two ways: a lump sum, or a series of scheduled payments. The beneficiary's taxable income is increased by the amount received during the course of the year, and ordinary income tax rates are applied to the annuity benefits.
The spouse of a deceased annuity owner can take the death benefit in the same manner as any other beneficiary with the same income tax liability results. However, an additional option available only to the annuitant's spouse allows the taxes that would otherwise be due immediately to be deferred until retirement. Spousal beneficiaries may opt to simply transfer ownership title of the annuity account into their own name, and continue the contract as originally written. This process defers taxation of the accumulated value and treats the annuity as if it were initially purchased by the spouse.
Annuitization converts the entire balance of the account into a predefined guaranteed stream of payments that last for the rest of the owner's life. If an annuity owner's death occurs after initiation of annuitization, the beneficiaries will only receive money if the contract provisions chosen by the owner accounted for continuation of payments. Owners can select an annuitization option that results in a higher monthly benefit, but forfeits any remaining monies still in the account after death. However, if the option chosen by the owner included continuation of benefits to heirs, beneficiaries will receive that value in the same manner as was originally arranged. All payments received in such situations increase the beneficiary's taxable earnings.
Gregory Gambone is senior vice president of a small New Jersey insurance brokerage. His expertise is insurance and employee benefits. He has been writing since 1997. Gambone released his first book, "Financial Planning Basics," in 2007 and continues to work on his next industry publication. He earned a Bachelor of Science in psychology from Fairleigh Dickinson University.