What happens to the money in an annuity when you die? It all depends on the type of annuity you are asking about. There’s not just one “annuity.” There are many different types of annuities, and all of them have unique death benefit features that you need to be aware of before purchasing or if you are a listed beneficiary on a policy.
The TaxMan Cometh
Are death benefits from an annuity taxable? The short answer is yes. Life insurance death benefits go lump sum and tax-free to the designated beneficiaries of the policy. I always say that life insurance is the best return on investment that you will never see...because you will be dead. Even though all annuities are issued by life insurance companies, annuity death benefits are fully taxable to the annuity policy beneficiaries.
The vast majority of life insurance is what’s called an “underwritten” product because you have to go through medical testing, blood work, etc. Annuities are “guaranteed issue,” which means that no underwriting is involved. If you are of sound mind and within the age requirements for that specific policy, the it will be issued.
Annuitized Death Benefits
Annuitization means to create payments. There are 3 primary types of annuities that distribute their payments through an annuitization structure. Those specific types are Single Premium Immediate Annuities (SPIAs), Deferred Income Annuities (DIAs), and Qualified Longevity Annuity Contracts (QLACs).
In addition, tax deferred annuity types like a Variable Annuity (VA), Fixed Index Annuities (FIAs), and Multi-Year Guarantee Annuities (MYGAs) can all be “annuitized” to create payments as well. You don’t have to convert those policies into payments, but you have that option.
Death benefits with annuitization comes down to how you structure the annuity contract. There are over 30 different contractual ways to structure the policy payments. Below are the main ones, and how the death benefits work with each. All of these can be issued “Single” life or “Joint” life.
*Life Only - This will provide the highest contractual payment regardless of how long you live, but when you die...the money goes poof. There is no death benefit.
*Life with Period Certain - This provides a guaranteed lifetime income stream, but with an attached “backstop” time period of your choice. You can choose the period certain at the time of application. For example, “Life with 20 Year Period Certain” means that it will pay regardless of how long you live...but if you died in year 8, your beneficiaries would receive 12 more years of payments. If you lived past the 20 year time period, there would be no death benefit...but the income stream would continue.
*Life with Installment Refund - This structure provides a lifetime income stream, but when you die...any money left in the account goes in payment form to the listed beneficiaries until the money is exhausted.
*Life with Cash Refund - This structure provides a lifetime income stream, but when you die...any money left in the account goes lump sum to the listed beneficiaries.
*Period Certain - This structure pays you or your listed beneficiaries (if you die) a specific time period of money that you choose. For example, a “15 Year Period Certain” pays 15 years, and then stops. If you die in year 7, then there will be 8 more years of payments to the listed beneficiaries.
These pension annuity death benefits are dependent upon how you specifically customize the payout at the time of application.
Non-Annuitized Death Benefits
For annuities that are not annuitized, the death benefit is the accumulation value of the policy. If you are the contract owner, that accumulation value can be paid out in 3 primary ways as a standard death benefit.
*Lump Sum - This is the amount your annuity has grown by during the deferral years up until your death.
*5 Year Pay - Some deferred annuities allow the annuity beneficiaries to be paid out the death benefit dollar amount over a 5 year time period in order to lessen the tax hit.
*Lifetime Annuitization - Some deferred annuities will allow you to “annuitize” and create a payment stream for life. This payment is based on the accumulation value at the time of the contract owner's death, and the life expectancy of the beneficiary at the time the payments start.
The premiums paid into the policy and the gains up to the death of the contract owner will determine what portion of the policy is taxable in a non-IRA account. IRA taxation rules apply to annuities inside of that structure, just like any other IRA asset.
Death Benefit Riders
Depending on the deferred type of annuity, some contracts offer you the choice of adding a death benefit rider to the policy. That specific rider is a separate calculation from the accumulation (i.e. real money) value of the policy and can only be used as a death benefit.
Most riders have a guaranteed minimum and offer an annual step up percentage growth to the death benefit calculation on the contract anniversary date. Many of these death benefit riders can also be used for retirement income as well, but those lifetime payments will decrease those enhanced death benefits when taken.
The majority of death benefit riders pay the beneficiaries a lump sum amount.
Tax Experts Please
All retirement plans should have some type of legacy plan in place. Regardless of how much you like your financial advisor, financial professional, or annuity agent...you need to work with a qualified professional when it comes to any tax questions.
Annuity death benefits options need to be fully understood by the contract owner and the policy beneficiaries, and the chosen strategy for the distribution of assets need to be approved by your tax professional.
If you are the owner of an annuity policy, the beneficiaries can be changed at any time up until your death. That’s good to know if there are life or family changes...which seems to always be the case.