What You Should Know About Annuities after the Owner’s Death

Annuities are long-term contracts from an insurance provider where you invest some amount, and you receive regular payments as income. Annuities are a big part of estate planning; they protect against market and longevity risk and grow interest tax-free, ensuring the owner receives protected income for a certain specified period or a lifetime and they die, beneficiaries receive death benefits.

A traditional annuity delivers regular payments to the beneficiary for a specified number of years or lifetime. A ‘deferred’ annuity allows a buildup of investment gains until a future date when payments to the beneficiary begin. However, not all annuities are that simple. There are more than a few types of annuity products to choose from, depending on your specific financial goal.

Most elderly members of the society use annuities to grow their retirement income, or for spousal protection, or as a way to provide for their children. Here’s a look at how annuities work after the owner (annuitant) dies.

Who gets an annuity after the owner dies?

Annuities held by parents, spouses, or any other loved ones can always be willed to beneficiaries. Annuity owners and their financial planners work with insurance providers to create contracts with suitable payout and beneficiary preferences.

Every annuity contract includes a death benefit provision where the owner can name a beneficiary to get the remaining annuity payments after their death. For example, with the death benefit provision, the owner can designate the beneficiary to receive all the remaining income or an absolute minimum, whichever is greater.

In the case of a joint or survivor annuity, the spouse inherits the annuity as the beneficiary and may choose to keep the contract going or opt for a death benefit.

Usually, the death beneficiary is specified in the initial application, but the owner can amend the beneficiary designation before his/her death. The annuity company will look into and confirm the beneficiary.

What do beneficiaries receive after the annuity owner dies?

Depending on whether the annuity was in the payout or accumulation phase, designated beneficiaries are entitled to either a series of payments or a lump sum death benefit.

An annuity is in the accumulation phase if the owner dies before payments begin. You can confirm the status from recent statements from the administrator of the annuity. If the statement shows regular payments going to the deceased accounts, the annuity is in the payout phase and vice versa.

Annuities in the payout phase

For annuities that had already begun making payments when the owner died, the beneficiary is not entitled to a death benefit. Instead, they are entitled to a payout option, usually stated in the contract. Here’s a breakdown of what happens to your annuity when you (the annuitant) dies after payments have begun:

  • No payment: in the case of life, the only contract, payments stop when you die. It can also happen if you are the only surviving annuitant.

  • Payments only continue if you die before a specified number of payments have been reached. It is the case with Life with Period Certain annuities; your beneficiaries only receive payments for the guaranteed period.

  • Payments continue to be paid to the survivor or joint owner of the contract until they die. The payment can be a full amount, just like you received while alive or a smaller amount, depending on the specifications made when establishing the contract.

Annuities in the accumulation phase

  • Beneficiaries of annuities in the accumulation phase can receive a lump sum equal to the greater of either the sum of premiums paid or the annuity’s current value. For a non-spouse beneficiary, you can choose to:

  • Receive a lump-sum payment, also known as a ‘blow-out.’

  • Convert the lump sum into a series of periodic payments over your lifetime or a certain number of years; this is called the stretch-out option and is available for non-spousal beneficiaries only.

  • Chose to continue the contract in case of a joint owner or sole spousal beneficiary.

Ask to be provided with the entire amount, five years after the annuitant’s death; this is also called the ‘Five Year Rule.’

Who can stretch out payments?

The stretch-out option allows a non-spouse beneficiary to pass on inherited annuities down their generation and minimize estate taxes. The option removes restrictions on wealth transfer and allows beneficiaries to receive a substantial sum of benefits spread over a more extended period.

The stretch-out option is only available to non-spousal beneficiaries of non-qualified annuities, i.e., annuities not held in IRAs. The payment amount is computed based on the inherited contract value and the beneficiary’s life expectancy at the time payouts begin.

Also, the IRS stipulates that beneficiaries must take out a minimum annual amount after the owner’s death. The advantage of stretching out payments is that the tax burden is spread over multiple years, and not just on the beneficiary, but their descendants who will inherit the annuity, too.

Annuities with enhanced death benefits

There’re also annuities with enhanced death benefits; these are usually variable annuities with a guaranteed annual step-up in their cash values. The death benefit can be set to increase according to the contract value or anytime its cash value clocks a new high.

Additional investments can also be made in the annuity to increase its death benefit. Variable annuity contracts’ death value cannot decrease once set but can decrease if the owner opts for a distribution.

Are inherited annuities taxable?

The income on an inherited annuity is subject to taxes. The tax depends on the annuity payout structure and whether the inheriting person is a spouse or another entity.

If the beneficiaries opt for a lump sum, they are taxed immediately. The tax is calculated on the difference between what the owner paid for the contract and the lump sum. But they can also spread the taxes over multiple years by annuitizing the distribution; only the gains on the yearly withdrawals will be taxed. The first option has the highest tax exposure; the second option has a reduced tax exposure. In all cases, taxes are owed only when money is taken out of the annuity.

Surviving spouses can elect to change the annuity contract into their names, so it remains as if they’ve owned it since the beginning; this allows the contract to keep its tax-deferred status. However, the option with the least tax exposure is the beneficiary choosing to spread the death benefits over their life expectancy.

Reporting income from an inherited annuity

Finally, the IRS requires beneficiaries to continue reporting income from inherited annuities just like the plan participant did. Survivors must include the income on their taxes.. Payments that are received from these annuities are treated as ordinary income.

Wrapping up

Finally, the IRS requires beneficiaries to continue reporting income from inherited annuities just like the plan participant did. Survivors must include the income on their taxes.. Payments that are received from these annuities are treated as ordinary income.