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

In the case of a deferred annuity that provides the beneficiary with the option to take the death benefit as a lump sum, the beneficiary will not be taxed on the gain in the year of death if the beneficiary elects “within 60 days after the day of which such lump sum first became payable” to apply the death benefit under a life income or installment option ( Q 588).⁴ The periodic payments then will be taxable to the beneficiary under the regular annuity rules ( Q 527 to Q 546). The exclusion ratio for the contract will be based on the decedent’s investment in the contract and the beneficiary’s expected return.⁵ See Q 592 for a discussion of the 60-day period discussed in this paragraph.

The rules described above apply to non-variable annuity contracts as well as to variable annuity contracts purchased after October 20, 1979, and to contributions made after October 20, 1979, to variable annuities issued prior to this date. If the owner of a variable annuity contract acquired prior to October 21, 1979, including any contributions applied to such an annuity contract pursuant to a binding commitment entered into before that date, dies prior to the annuity starting date, the contract acquires a new “step-up” cost basis. The basis of the contract in the hands of the beneficiary will be the value of the contract at the date of the decedent’s death, or the alternate valuation date. If that basis equals the amount received by the beneficiary, there will be no taxable gain and the appreciation in the value of the contract while owned by the decedent will escape income tax entirely.⁶ However, where a variable annuity contract purchased before October 21, 1979 had been exchanged for another variable annuity contract under IRC Section 1035 after October 20, 1979, and the annuity owner died prior to the annuity starting date, the beneficiary was not entitled to a step-up in basis.⁷ Although the aforementioned step-up in basis treatment for pre-October 21, 1979 annuities has only been directly ruled on in the case of a variable annuity, it also would theoretically apply to fixed annuities issued prior to October 21, 1979.

Normally the death benefit is payable at death. If it is not payable until a later time and the annuitant also was the owner of the annuity contract, see Q 593.