Annuities are a way to ensure a regular payout in retirement, but what happens if you die before or while you are receiving payments from your annuity? This article will explain the basics of annuity death benefits, including who can receive them and how. Read on for answers to questions like:
- Do beneficiaries have to pay taxes on annuities?
- What annuity beneficiary payout options exist?
- What happens if a beneficiary is not named?
- What is an annuity death benefit?
Annuities pay out a set amount over time to you during your retirement. If you die before initiating those payments, your loved ones can collect money from the annuity in the form of a death benefit. This ensures that the beneficiaries benefit from the funds that you have saved or invested in the annuity contract.
Do annuities have beneficiaries?
Beneficiaries are important because they collect the payout from your annuity after you die. A primary beneficiary is designated by the annuity owner to receive the death benefit upon their death. (NOTE: The owner is usually the annuitant, or person whose life the death benefit is contingent upon, but could be a different person.) The primary beneficiary has the first right to claim those funds.
Do annuities have secondary beneficiaries?
A secondary beneficiary, also known as a contingent beneficiary, is next in line to receive the death benefit if the primary beneficiary is unable or unwilling to collect it. The secondary beneficiary would only be eligible to receive the death benefit if the primary beneficiary predeceases them.
How to choose beneficiary types
You must choose your annuity beneficiary when purchasing an annuity that includes a death benefit. This can seem like a simple decision, but there are factors and potential ramifications to consider including age, tax status and financial circumstances when choosing beneficiaries.
Many people think only of beneficiaries as individuals, but it is also possible to name an institution such as a trust or charity as an annuity beneficiary. People will often choose a spouse as the primary beneficiary, with any children as the secondary beneficiaries. It is important to keep your list of beneficiaries updated. For example, a divorce might prompt an update to your designated beneficiary.
What happens if a beneficiary is not named?
Does a beneficiary on an annuity supersede a will? The annuity death benefit applies to beneficiaries independently of the will. This means the annuity benefit goes to the most recently designated primary beneficiary (or the secondary, if the primary beneficiary has died or is incapable of collecting).
Things become problematic if you don't name a beneficiary for the annuity death benefit. That makes it more complex to get the annuity funds to the intended person after you pass.
In most states, an annuity without a beneficiary becomes part of your estate and will be paid according to your will. That involves a probate process, in which a deceased person's property is assessed and their will verified before paying any outstanding taxes or debts and then distributing to beneficiaries. Probate fees can eat into the annuity benefit.
Can annuity beneficiaries be contested?
It is extremely difficult to challenge a standing contract, and the bar for proving such a case is extremely high.
What happens to an annuity when you die?
What happens to an annuity upon the death of an owner/annuitant depends on the type of annuity and whether or not annuity payments had initiated at the time of death.
If the owner/annuitant dies prior to initiating annuity payments, the named beneficiary would receive the death benefit. However, if annuity payments have begun, whether or not payments will continue to a named beneficiary would depend on the type of annuity payout chosen.
A straight-life annuity payout will pay for the life of the annuitant with payments stopping upon their death. A period-certain annuity pays out for a certain period of time, meaning that if the annuitant dies during that time, payments would pass to a beneficiary for the remainder of the specified period.
There are also different death benefit options available with certain annuity contracts:
- Standard death benefit — This pays the annuity's contract value at the time of the annuitant's death.
- Return of premium death benefit — This payout returns the total premiums paid into the annuity (less prior withdrawals), or the account value, whichever is larger.
- Enhanced death benefit — This offers enhancements to increase the value of the death benefit. One example of an enhanced benefit is a stepped-up benefit. This is a rider available with certain annuities that increases the annuity's death benefit to the highest value achieved according to a predetermined assessment schedule. For example, the death benefit may be calculated by matching it to the highest contract value achieved within a calendar quarter.
Death benefit payout options
There are several payout options that also apply to an annuity beneficiary. Death benefits can be paid as a lump sum, in which the beneficiary takes the entire amount in a single payment. Alternatively, they can take the payment over a specified period. Finally, if there is a provision in the annuity contract that allows it, a beneficiary can take payments in a nonqualified “stretch.” This can enable them to receive payments for the rest of their lives.
With some annuities, the insurer will often charge a mortality and expense (M&E) fee. This reflects the risk that they're taking on when they take out a contract with you. If your health changes unexpectedly and you die before you have paid the necessary premiums to cover the death benefit, the insurance company could be out of pocket when it pays the beneficiary. The M&E fee addresses that risk by charging a percentage of your contract value.
Are annuity death benefits taxable?
Are annuities taxable to beneficiaries? Yes, annuity beneficiaries must pay taxes on those funds, but instead of inheritance tax or estate tax, they pay regular income tax. Their tax payments depend on the annuity and the payout structure.
How much tax is paid depends on the nature of the annuity. Owners of a qualified annuity purchase it through a retirement account like an IRA or 401(k). That means they haven't paid tax on the money they use to fund the account. The beneficiary must therefore pay income tax on both the earnings and premiums when withdrawing funds.
Conversely, you have already paid taxes on the principal you pay into a non-qualified annuity. That means beneficiaries only pay tax on the earnings.
Do beneficiaries pay tax on inherited annuities as soon as they inherit? No, they pay taxes on each withdrawal at the time they make it. If they take a lump sum payout, they pay taxes on that all at once, which could push them into a higher tax bracket. Regular periodic withdrawals spread out taxes over time.
- Annuity death benefits allow your loved ones to receive payment from your annuity should you pass away prior to beginning annuity payments.
- There are options to allow for payment to beneficiaries even after annuity payments to the owner have initiated.
- It is important to choose beneficiaries based on factors including age, relationship, and financial status.
- Annuities with death benefits typically include fees to cover the insurance company's risk.
- Annuities can include enhanced riders that increase the death benefit value to beneficiaries.
- Beneficiaries must pay tax on annuity death benefits, but structured payouts can provide some tax relief.
As you determine what annuity might be right for you, remember they are intended as vehicles for long-term retirement planning, which is why withdrawals reduce an annuity's remaining death benefit, contract value, cash surrender value and future earnings. Annuities also may be subject to income tax and, if taken prior to age 59 ½, an additional 10% IRS tax penalty may apply. Because Protective and its representatives do not offer legal or tax advice, it is important that you talk with your own legal and tax advisor about your specific tax situation.