3976 / How is an employee’s beneficiary taxed on death benefit payments from a qualified plan when the employee dies after retirement?

If an employee had no cost basis for his or her interest, or has recovered his or her cost basis from benefits received during the employee’s life, all amounts received by the beneficiary will be fully taxable. The beneficiary may be entitled to an income tax deduction for any estate tax attributable to the employee’s interest in the plan.¹

Joint and Survivor Annuity

The method of taxing survivor annuity payments to a beneficiary depends on how the employee was taxed ( Q ).

If the employee was taxed on everything, the survivor annuitant will be taxed on everything as well.²

If the employee was taxed under the three year cost recovery rule in existence with respect to annuities with starting dates prior to July 1, 1986, and had not recovered his or her full cost basis, the survivor will receive the guaranteed payments tax-free until the total of the employee’s and survivor’s tax-free receipts equals the employee’s cost basis; thereafter everything will be includable in gross income.³

If the employee was taxed under regular annuity rules or under the safe harbor method, the survivor will continue with the same exclusion ratio,⁴ but if the employee’s annuity starting date was after December 31, 1986, no amount is excludable by the employee or beneficiary after the investment in the contract has been recovered.⁵

Refund Beneficiary

If the employee had a cost basis for the employee’s interest and had not recovered the full amount tax-free, a refund beneficiary under a life annuity with a refund or period-certain guarantee can exclude the balance of the cost basis from gross income ( Q ). Otherwise, everything received by the beneficiary is taxable.⁶

If the beneficiary receives the refund in a lump sum distribution, the lump sum distribution rules apply ( Q 3971). If the beneficiary surrenders an annuity contract that has been previously distributed to the employee, the payment does not qualify for lump sum treatment because it is not viewed as a distribution from the trust but as a payment in settlement of the insurer’s liability to make future payments.⁷

If the beneficiary receives the refund in installments, the payments are taxable as ordinary income.

If the refund beneficiary of a decedent whose annuity starting date was after July 1, 1986, does not fully recover the cost basis unrecovered at the decedent’s death, the refund beneficiary may take a deduction for the remaining unrecovered amount.⁸

Installment Payments

Where payments for a fixed period or of a fixed amount, not involving a life contingency, had commenced to the employee, tax consequences to the beneficiary can differ, depending on whether the installments are continued or are commuted and paid to the beneficiary in a lump sum.

In addition, the balance, if any, of the lump sum payment is taxable under the lump sum distribution rules.

If installments are continued, the method of taxing payments then will depend on how the employee was taxed ( Q ). If the employee was taxed on everything, the beneficiary also will be.⁹ If the employee was taxed under the three year cost recovery rule in existence for annuities with starting dates prior to July 1, 1986, and had not recovered his or her full cost basis tax-free, the beneficiary can exclude the balance from the first payments received. Thereafter, everything is taxable.¹⁰

If the employee was taxed under regular annuity rules or under the safe harbor method, the beneficiary will continue to exclude the same portion of each payment from gross income.¹¹

If the annuity starting date was after December 31, 1986, the beneficiary can exclude amounts only until the investment in the contract has been fully recovered; thereafter, all amounts are included in income.¹²