Annuities are popular retirement investment vehicles offered by insurance companies. These products can be held within retirement accounts like IRAs and 401k plans, or purchased privately and funded with after-tax dollars. Because annuities are insurance products, there are often enhanced death benefit options that can be added to the contract, complicating the tax liability for beneficiaries.
Qualified Versus Non-Qualified
Qualified annuities are those held inside formal retirement plans like IRAs, 401k plans and similar employer-sponsored platforms. Contributions into qualified annuities result in income tax deductions, and the entire amount of any withdrawal is subject to ordinary income tax. Non-qualified annuities are those purchased independently and funded with after-tax dollars. No tax deduction is available for deposits into non-qualified annuities, but growth within these accounts accumulates tax-deferred. Only upon withdrawal of the money are taxes due on the growth portion.
If Death Occurs During Accumulation
If an annuity owner dies before the contract is annuitized, or converted into a guaranteed stream of payments, the total value of the account shall pass to the designated beneficiary. If the beneficiary chooses to take the proceeds as a single lump sum, taxes are due on any portion that has yet to be taxed. In the case of a qualified annuity, the entire balance of the account will be added to the beneficiary’s taxable income for the year; if the annuity is non-qualified, only the portion of the account value above the original owner’s contributions will be added to the beneficiary’s taxable income.
If Death Occurs After Annuitization
If an annuity owner dies after the contract has been annuitized, and payments are still owed to the beneficiary due to the original owner’s choice of payout options, all remaining payments will be directed to the beneficiary until the expiration of the guaranteed period. Distributions received by the beneficiary during the remainder of the payout period will result in income tax liability that is equal to what the original owner would have owed, which is tax liability for only a portion of each payment called an “exclusion ratio.”
The Spousal Beneficiary
If an annuity owner’s beneficiary is a spouse, a special exception to established distribution and taxation rules is available. The owner’s spouse may elect not to receive the value of the annuity as a lump sum death benefit, and instead may continue the annuity contract as the new owner. By taking advantage of this exception to the death benefit distribution rules, an annuity owner’s spouse may further delay payment of taxes on accumulated retirement money.
Regardless of whether an annuity owner’s beneficiary is a spouse or non-spouse, upon his death the entire account value is included in calculating estate tax liability. If death occurred during the accumulation phase, prior to annuitization, all of the annuity’s value is added to the estate. If death occurred after the contract was annuitized, only the total value of those remaining payments is added to the owner’s estate.
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.