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Retirement Planning > Retirement Investing > Annuity Investing

How Do Annuity Death Benefits Work?

By Roger Wohlner

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What You Need to Know

  • Not all annuities have a death benefit.
  • The options for beneficiaries will vary based on factors such as whether or not the contract has been annuitized prior to the owner’s death.
  • Tax rules for annuity death benefits depend on whether the annuity is qualified or nonqualified; the taxes can be significant.

Annuities are primarily known for their living benefits, but in many cases, they can offer a death benefit to the contract holder’s beneficiaries. If your client has an annuity or is considering investing in one, it’s important to review the contract’s death benefit options with them. Not all annuities have a death benefit. 

What Is an Annuity Death Benefit?

An annuity death benefit is a payment made to the beneficiary of an annuity contract holder upon their death.

Death benefit options can vary based on whether the contract has been annuitized and other factors including the type of annuity and the insurer who issued the contract.

What Happens When the Annuity Contract Owner Dies?

If the owner has begun to annuitize the contract, payments could end upon their death unless they have named a beneficiary. This would also be the situation if the contract was annuitized for a single life only with no named beneficiary.

If they have named one or more beneficiaries, then the beneficiaries may continue to receive the annuity payments either for the rest of their lives or a set period, depending upon the annuitization method chosen by the contract owner.

If the annuity payments had not yet started at the time of the contract holder’s death, the value of the contract will generally pass to any beneficiaries named on the contract. The amount that the beneficiaries receive will depend upon the terms of the annuity contract. The beneficiaries may receive a lump-sum payment based on the current value of the contract, or there may be a number of other payment options for beneficiaries.

Lump-Sum Death Benefits

This is a standard death benefit on most annuities where the contract was not annuitized at the time of the contract owner’s death. With a lump-sum payment, the contract’s beneficiaries receive the full value of the remaining premiums plus earnings left in the contract. There may be fees that are deducted from the payment amount.

Generally, any contract earnings included in the payment amount will be taxable in the case of a nonqualified annuity. The portion of the payment that pertains to premiums contributed is not taxable. The portion associated with earnings on the account would be taxable to the beneficiaries as ordinary income.

How Annuity Death Benefits Work: Examples

There are a number of annuitization options across various types of annuities and various insurers. Here are some annuitization examples and how the death benefit can work.

Annuitization – Life Only

If the contract has commenced annuitization at the time of the contract holder’s death and they had chosen to annuitize for their lifetime only, the annuity payments will cease upon their death. The value of the annuity will revert to the insurance company. This type of annuitization generally results in the highest benefit level and may be appropriate for an annuitant seeking the highest monthly payment and who either doesn’t have beneficiaries they need to consider or who has other assets or life insurance in place to provide death benefits to their heirs.

Annuitization – Joint and Survivor

An annuity might be annuitized on a joint and survivor basis. This is often done between spouses. With joint and survivor annuitization, annuity payments run for the life of both annuitants, ceasing when the last annuitant dies.

A joint and survivor annuity provides a percentage of the initial annuity payment to the survivor. This could be 100%, 50% or some other percentage. The higher the percentage that goes to the survivor, the lower the initial payments to the annuitant. Typically, payments cease with the death of the survivor.

Annuitization – Life With Period Certain

In this case, payments continue for the lifetime of the contract holder (or the contract holder and their spouse if a joint-life annuity), with a guaranteed minimum period for the payments to last. Period-certain durations of 10 or 20 years are common. If the annuitant dies prior to the end of the period, their beneficiaries receive payments for the remainder of the period. For example, with a life and 20-year period-certain annuity, if the annuitant dies in year 15, then the beneficiaries would receive the remaining five years’ worth of payments.

Annuitization – With Period Certain Only

With this type of annuitization, income is paid for a set period of years. If the contract holder dies before the end of the duration of the period certain, their beneficiaries receive payments for the rest of the designated time period.

Annuitization – Life With Refund

Under this annuitization scenario, payments are made for the life of the annuitant. The insurer guarantees that the payments to either the annuitant or their beneficiaries will be equal to at least the amount of the premiums that the contract owner paid into the contract. If the annuitant dies before this occurs, the remainder of the payments will be made to the contract beneficiaries.

Annuity Death Benefit Riders

Depending upon the insurer and the type of annuity, annuity contract owners may have an option to add an enhanced death benefit rider to the contract. The payment terms of these riders will vary but they can be a way to ensure your client’s beneficiaries receive a payout from the contract when your client dies. As with most contract riders, there is a cost to a death benefit rider that can reduce the contract owner’s living benefits. 

Qualified vs. Nonqualified Annuities

With a qualified annuity that is held inside of an IRA or other type of retirement plan, the death benefit will be governed by the beneficiary designations on the plan. The annuity is considered an asset of the IRA, 401(k) or other type of qualified plan and the distribution rules upon death for that type of retirement plan governs.

If the spouse is the beneficiary, he or she will have several options including taking the money within five years or treating the IRA as their own. Most non-spousal beneficiaries are required to take the funds within 10 years under the Secure Act rules for inherited IRAs.

For nonqualified annuities purchased with after-tax money, the beneficiary or death benefit rules of the annuity contract govern. There may be an option for spousal continuance in some cases. Some beneficiaries may be required to withdraw the proceeds of the annuity within five years. As discussed above, a lump-sum distribution is a common option, especially if the contract had not been annuitized prior to the owner’s death.

Are Annuity Death Benefits Taxable?

In the case of a qualified annuity, the tax rules for distribution to the account beneficiaries will govern. If the annuity was held in a Roth IRA, the distribution to non-spousal heirs may not be taxed if the owner had met the requirements of the five-year rule prior to their death.

If the contract was held in a traditional IRA or other traditional retirement account, then the death benefit proceeds will generally be taxed. This includes both the earnings in the contract plus the amount of the contract’s premium. In most cases, a spousal beneficiary will have the option to treat the account as their own, avoiding immediate taxation.

In the case of a nonqualified annuity, the earnings portion of the annuity is taxed upon withdrawal. The premiums paid into the annuity by the original contract owner are generally not taxable. If the beneficiary, including a spouse, takes the benefit as a series of payments over time then the exclusion ratio applies. This means that a portion of each payment is taxable, the portion applying to the premiums is not.

Annuity Death Benefits and Estate Planning

Annuities can be complicated when looking at them as a retirement planning vehicle. When you add in the death benefit and how that might play into your client’s estate planning desires as far as leaving a legacy for their heirs, they become even more complex. While a number of death benefit issues and options were discussed above, this is not a complete list in that there is a wide range of contracts, and some may have death benefit options that differ a bit form what was outlined above. 

For a pure death benefit, life insurance may be the better choice. But annuities offer the benefit of guaranteed income for life and the death benefits can be lucrative in some cases. Your clients need your help in combining the retirement benefits of an annuity with advice for optimizing the contract’s death benefits for their heirs.

Roger Wohlner

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