591 / If an annuitant dies before a deferred annuity matures or is annuitized, is the amount payable at the annuitant’s death subject to income tax?
An annuity contract generally provides that if the annuitant dies before the annuity starting date, the beneficiary will be paid, as a death benefit, the greater of the amount of premiums paid or the accumulated value of the contract (although some contracts may provide additional “enhanced” death benefits as well).
The gain, if any, is taxable as ordinary income to the beneficiary, and is measured by subtracting (1) investment in the contract (reduced by aggregate dividends and any other amounts that have been received under the contract that were excludable from gross income) from (2) the death benefit, including any enhancements ( Q 515).1 The gains are taxable when received, and are taxable to the beneficiary that receives the payments (not the decedent). Thus, annuities do not receive a step-up in basis at death (except for certain pre-October 21 1979 grandfathered annuities; see later in this section for further discussion).
The death benefit under an annuity contract does not qualify for tax exemption under IRC Section 101(a) as life insurance proceeds payable by reason of the insured’s death. Instead, death benefits paid on the death of the owner or the annuitant are income-in-respect-of-a-decedent (“IRD”) to the extent that the death benefit amount exceeds the basis in the annuity contract. As a result, the beneficiary may be eligible for a special income tax deduction for any federal estate taxes paid that were attributable to the IRD.2 The IRS has ruled that an assignment of an annuity from a decedent’s estate to a charity will not cause the estate or its beneficiaries to be taxed on the proceeds of the annuity.3