How are annuity death benefits taxed?

When an annuity owner dies, the remaining annuity value is paid out to individuals who have been named as beneficiaries. The death benefit can create a financial windfall for beneficiaries, but it will have various tax implications depending on the type of annuity and your beneficiary status.

The tax you pay on annuity death benefits depends on whether you have a qualified or non-qualified annuity. If you have a qualified annuity, the death benefits you receive from the annuity are subject to ordinary income taxes. However, if you have a non-qualified annuity, you won’t pay income taxes on the contributions portion of the distributions since they have already been taxed; you will only pay income taxes on the earnings portion of the distribution.

What is an annuity death benefit?

An annuity death benefit is a form of payment made to a person identified as a beneficiary in an annuity contract, usually paid after the annuitant dies. Most annuity products come with a death benefit provision, which allows the annuity owner to name a beneficiary to receive the remaining annuity balance when they pass away. The beneficiary can be a child, spouse, parent, etc. 

The amount of death benefit payable to a beneficiary may be the full value of the annuity or the amount left in the annuity at the time of the annuity owner's death. If the annuitant had started receiving annuity payments, these payments and any applicable fees are deducted from the death proceeds.

If the annuity does not include a death benefit provision, you may be required to pay an additional fee to purchase a death benefit rider. In this case, the annuity would provide a guaranteed death benefit to the beneficiary, regardless of the remaining annuity balance.

Are annuity death benefits taxable?

Annuity death benefits are subject to income taxes, but the taxes you pay depend on how the annuity was funded

Qualified and non-qualified annuities have different tax implications. Qualified annuities are funded with pre-tax money, and this means the annuity owner has not paid taxes on the annuity contributions. The money in a qualified annuity is sheltered from income taxes while it is in the account. When the death benefits are paid out, the IRS considers these benefits as income and will be subject to ordinary income taxes.

Non-qualified annuities are funded with after-tax dollars, meanings the contributions have already been taxed, and the money won’t be subject to income taxes when distributed. However, any earnings on the annuity contributions grow tax-deferred, and you will pay income taxes on the earnings part of the distributions.

Tax rules of inherited annuities

Spouses and non-spouse beneficiaries may have different options with the inherited annuity, which can allow them to reduce or defer annuities.

Surviving spouse inherits the annuity

If you are a surviving spouse, you can continue the annuity contract as the owner if you are a joint owner or the sole beneficiary. This provision is known as a spousal continuation. After changing the annuity ownership, the surviving spouse becomes the annuity owner, and he/she will continue to enjoy the tax-deferred status and won’t owe immediate taxes.

The surviving spouse maintains the payment options available to the original annuitant. They can choose to annuitize the contract and receive periodic payments over time or for the rest of their life or take a lump sum payment. Each payment option has different tax implications; a lump sum payment has the highest tax consequences since the payment can push you to a higher income tax bracket.

Non-spousal beneficiary inherits the annuity

Different rules apply for non-spouse beneficiaries such as a child, parent, or other relatives. The amount of income taxes you pay depends on how you receive payments from the annuity. If the beneficiary chooses to take a lump sum payment, they must pay income taxes immediately.

A non-spouse beneficiary can choose annuitized payments, which are spread for a specified period or the rest of their life. This option spreads the tax liability for annuity payments over time. You can also use the 5-year rule, which lets you spread the inherited annuity payments over five years; you will pay taxes on the distributions you get each year.

How are death benefits paid?

Beneficiaries inheriting an annuity have several options to receive annuity payments after the annuity owner’s death. They include:

Lump sum distribution

The beneficiary can opt to receive the remaining value of the annuity contract in a single lump sum payment. The money will become taxable in the year it is received.

Non-qualified stretch provision

This option uses the beneficiary’s life expectancy to determine the size of the annuity payments. It provides annuity payments that the beneficiary is entitled to according to their life expectancy.

Five-year rule

This rule requires beneficiaries to take out annuity payments within five years. They can take multiple payments over the five-year period or as a single lump-sum payment, as long as they take the full withdrawal by the 5^th anniversary of the annuity owner’s death.

How to avoid paying taxes on inherited annuity

While you cannot completely avoid paying taxes on an inherited annuity, there are certain things you can do to lower or defer the tax payments. Here are things you can do:

Surviving spouse

As a surviving spouse or a deceased annuitant, you can take ownership of the annuity and continue enjoying the tax-deferred status of an inherited annuity. This allows you to avoid paying taxes if you keep the money in the annuity, and you will only owe income taxes if you receive annuity payments.  

1035 exchange

If you exchange your inherited annuity for another annuity, you can avoid paying income taxes on the transaction. However, the 1035 exchange only applies when you exchange similar annuities. For example, you can exchange a qualified annuity for another qualified annuity with better features. However, you cannot exchange a qualified annuity for a non-qualified annuity.

Enhanced death benefit

Some annuity contracts offer special riders with an enhanced death benefit. This benefit is a bonus that will be paid to your beneficiaries when they inherit the remaining balance in your annuity. The beneficiaries will still pay taxes on the inherited annuity, but the bonus can help offset the tax benefit.

Rollover to an inherited IRA

If you inherited a qualified annuity, you may be eligible to transfer these funds to an inherited IRA. However, this option is only available to eligible designated beneficiaries such as a minor child, surviving spouse, etc.