- Annuity contract terms do not always change when the primary annuitant passes away. Depending on the type of annuity purchased, it may continue paying out the same way it had done for the original annuitant.
- Taxes owed on an inherited annuity will depend on the payout structure and the status of the beneficiary. Lump sums are taxed immediately with the highest tax consequences.
- Only the original annuity contract holder can choose their beneficiaries. Spouses of inherited annuities can update the list of beneficiaries.
What Happens to an Annuity When You Die?
Depending on the terms of the contract, annuity payments will end after the death of the annuity owner. But annuities that have a death benefit allow the owner to designate a beneficiary to receive the greater of either all the remaining money or a guaranteed minimum.
This means an annuity held by a parent, spouse or another loved one can be willed to a person named as a beneficiary.
Annuity owners work with insurers to design contracts specifying payouts and beneficiaries. After the annuitant passes, any remaining funds are given to beneficiaries as a lump sum or installments. It’s vital to include a beneficiary in the annuity contract to avoid losing assets to a financial institution upon the owner’s death. If the annuitant dies before the annuity begins, beneficiaries typically receive a lump-sum. If they die after, they will usually continue receiving the annuity payments.
Like setting up a life insurance policy, owners can customize their annuity contracts to support their loved ones. The number of payments remaining upon the death of the owner depends on the details outlined in the contract, including the type of annuity purchased and the inclusion of the death benefit clause.
Naming annuity beneficiaries ensures that your money is distributed correctly, the way you want it to be. If your annuity provides retirement income and you have a spouse, ensuring proper beneficiary designation may prevent disruption to their income when you pass.
Inherited Annuity Payout Options
Beneficiaries inheriting an annuity typically have three options for how to receive annuity payments after the contract owner’s death.
“It is important to name a beneficiary on your annuity so that the remainder can go to whom you would like it to at your death,” Kendall Meade, Certified Financial Planner® professional at SoFi, told Annuity.org. “Sometimes your monthly amount will continue to your beneficiary for their life, sometimes it may be for a specific amount of time and other times they may get a lump sum.”
- Lump-Sum Distribution
- A lump-sum distribution allows the beneficiary to receive the entire remaining value of the contract in one payment.
- Non-Qualified Stretch Provision
- When a non-qualified stretch provision is included in the contract, the beneficiary receives payments based on his or her life expectancy.
- Five-Year Rule
- The five-year rule allows beneficiaries to withdraw incremental amounts during a five-year period or withdraw the entire sum in the fifth year.
Beneficiary Payout Options
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What’s the Difference Between Annuitant and Owner?
It’s important to clarify that an annuity owner and an annuitant are not always the same person.
Insurance companies refer to the annuity purchaser as its owner. The owner creates the annuity terms with the insurance company and has automatic rights over the agreement. The owner can designate beneficiaries and can sell or exchange the annuity.
There can be co-owners of an annuity, so if one owner dies, the other will retain the rights of the agreement. Co-owners are typically spouses.
While establishing the terms of the annuity agreement, the owner has the option of naming a third party as the annuitant. The annuitant is the person on whose life expectancy the contract is based. It is common for the annuity owner to name him or herself as the annuitant.
However, sometimes an annuity owner elects to name a younger representative as the annuitant to stretch out payments and extend the tax liability.
Owners are often annuitants, and the annuity benefit payments are calculated based on the annuitant’s life expectancy.
A beneficiary is a person who receives the death benefits, usually the remaining contract value or the amount of premiums minus any withdrawals, upon the annuitant’s death. An owner cannot be his or her own beneficiary.
If an existing annuity lacks a beneficiary, the remaining funds will be surrendered to the issuing bank or financial institution.
Choosing a Beneficiary
Only an owner can designate beneficiaries, and only the owner or annuitant’s death can trigger any beneficiary action. The owner can change beneficiaries at any time as long as the contract does not require an irrevocable beneficiary to be named. They can also choose multiple beneficiaries and a contingent beneficiary — people designated to receive payments if the primary beneficiary dies before the owner.
Beneficiaries can be people or organizations.
Why It’s Important To Name a Beneficiary
Naming a beneficiary ensures that the designated people and organizations receive the specified amount or percentage of the annuity contract. By designating a beneficiary for your annuity, you can eliminate any confusion about where the contract’s value should go if you pass away.
“It is important to name a beneficiary on your annuity so that the remainder can go to whom you would like it to at your death.”
— Kendall Meade, CFP® at SoFi
Additionally, having a beneficiary can simplify transferring your assets to your heirs. You can protect your heirs from having to go through probate if you name them as beneficiaries on your annuity contract.
Probate is the legal process of distributing a deceased person’s estate. The costly and time-consuming process involves identifying and appraising the deceased person’s property, proving in court that their will is valid and paying any debts or taxes the deceased person owed.
The prolonged legal procedures of probate can result in hefty attorney and court fees, which are paid from estate property. This means you’ll have less money to leave to your beneficiaries once the probate process is complete.
When owners fail to name beneficiaries, the annuity can go through probate and assets may be forfeited to the issuing insurance company. Owners who are married should not assume their annuity automatically passes to their spouse. Often they go through probate first.
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✓ Help protect your savings from market volatility
✓ Guarantee income for life
✓ Safeguard your family
✓ Help you plan for long-term care
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Factors To Consider When Choosing Beneficiaries
When choosing a beneficiary, consider factors such as your relationship with the person, their age and how inheriting your annuity might affect their financial situation.
Different types of annuity beneficiaries are treated differently by estate law and tax law. The beneficiary’s relationship to the annuitant usually determines the rules they follow. For example, a spousal beneficiary has more options with how they can deal with an inherited annuity and is treated more leniently with taxation than a non-spouse beneficiary, such as a child or other family member.
If the owner does decide to name a child or grandchild as a beneficiary to their annuity, they should know that minors designated as beneficiaries can’t access their inherited annuity until they reach the age of majority (18).
It’s important to understand the financial circumstances the beneficiary is in and how inheriting an annuity will affect them. For example, an annuity owner probably doesn’t want to name someone who receives government benefits as a direct beneficiary. The proceeds from the annuity might be enough to exclude them from receiving those benefits.
Types of Annuity Beneficiaries
As previously mentioned, the type of beneficiary an annuity owner chooses affects what the beneficiary can do with their inherited annuity and how the inheritance proceeds will be taxed. Spouses receive the most privileges as annuity beneficiaries.
Many contracts permit a spouse to determine what to do with the annuity after the owner dies. A spouse can choose to change the annuity contract into their name, assuming all rules and rights to the initial agreement and delaying immediate tax consequences. They will have the ability to collect all remaining payments and any death benefits and choose beneficiaries. The spouse then becomes the new annuitant.
When a spouse becomes the annuitant, the spouse takes over the stream of payments. This is known as a spousal continuation. This clause allows for the surviving spouse to maintain a tax-deferred status and secure long-term financial stability. Joint and survivor annuities also allow for a named beneficiary to take over the contract in a stream of payments, rather than a lump sum.
A non-spouse can also become a beneficiary; however, they will not have the ability to change the terms of the annuity contract. A non-spouse only has access to the designated funds from the annuity owner’s initial agreement.
Annuity owners can choose to designate a trust as their beneficiary. Doing so can help control the distribution of assets, but there can be tax complications when placing an annuity in a trust.
You also have the option of naming a charitable organization as your annuity’s beneficiary. If you choose to name a charity as your beneficiary, then the proceeds are free from income tax.
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Updating and Reviewing Beneficiaries
After you’ve selected and named your beneficiary or beneficiaries, you must continue to review your selections at least once a year. Forgetting to update beneficiary information is a common oversight for many annuity owners. By keeping your designations up to date, you can ensure that your annuity will be handled according to your wishes should you pass away unexpectedly.
Besides an annual review, major life events can prompt annuity owners to take another look at their beneficiary selections.
“Someone might want to update the beneficiary designation on their annuity if their life circumstances change, such as getting married or divorced, having children, or experiencing a death in the family,” Mark Stewart, CPA at Step By Step Business, told Annuity.org.
To change your beneficiary designation, you must reach out to the broker or agent who manages your contract or the annuity provider itself. Usually, there’s a simple form to fill out to change the beneficiary’s information on the annuity contract.
As with any financial product, seeking the help of a financial advisor can be beneficial. A financial planner can guide you through annuity management processes, including the methods for updating your contract’s beneficiary.
Are Inherited Annuities Taxable?
Inherited annuities are taxable as income. The payout option the beneficiary chooses for a tax-deferred annuity will determine how the income benefit will be taxed.
If the beneficiary is the annuitant’s spouse, the spouse can change the contract into his or her own name. After a change in ownership, the contract continues as if the surviving spouse owned the original contract. It maintains its tax-deferred status, meaning the beneficiary owes no immediate taxes.
The spouse could choose to take an immediate lump sum. This is an option for other beneficiaries, as well. In this situation, the beneficiary will owe taxes on the entire difference between what the owner paid for the annuity and the death benefit. This option has the highest tax consequences for the beneficiary.
The beneficiary can also withdraw the money over a period of five years. At that time, he will owe taxes only on the increased value of the portion that is withdrawn in that year. This option makes it less likely that the beneficiary will fall into a different tax bracket. Going to a higher tax bracket means higher taxes.
An option with a lower tax exposure is to have the death benefits paid over the life expectancy of the beneficiary. Because the benefits will be paid out over a longer period of time, the tax liability is also spread out over a longer period, making it less burdensome.
Reporting Inherited Annuity Income to the Government
Inherited annuity income should be reported to the IRS as a general rule, the same way the plan participant would have reported it. However, there are exceptions to this.
According to the Internal Revenue Service, survivors under a joint and survivor annuity held by retirees must include these benefits in their gross income reported to the government. These benefits should be included in the same way the retiree would have included them in gross income.
The IRS advises: “If you receive guaranteed payments as the decedent’s beneficiary under a life annuity contract, don’t include any amount in your gross income until your distributions plus the tax-free distributions received by the life annuitant equal the cost of the contract. All later distributions are fully taxable. This rule doesn’t apply if it is possible for you to collect more than the guaranteed amount. For example, it doesn’t apply to payments under a joint and survivor annuity.”
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Annuity Beneficiary Options
Annuity owners provide a sum to beneficiaries that is predetermined by the type of death benefit written into the annuity contract. Primary death benefit options include standard, return of premium and riders.
Standard Death Benefit
This benefit has the least value, and the owner does not incur any extra costs. The insurance company pays beneficiaries the value of a contract, less any fees and withdrawals. The contract value is determined by the day the insurance company receives proof of the annuitant’s death or when the beneficiary files a claim. For some variable annuities, this benefit can decrease in value. For example, a beneficiary might report the annuitant’s death on a date when stocks are underperforming.
Return of Premium
Return of premium has a higher value and may cost an additional 0.05% a year, while some contracts include this death benefit at no extra cost. With the return of premium benefit, either the market value of the contract or the sum of all contributions minus fees and withdrawals determines the inherited amount. The insurance company pays whichever is greater.
Stepped-Up Death Benefit Rider
A rider is a provision to a contract that can be added when the contract is created. With annuity death benefit riders, there can be an annual fee over the life of the policy. The riders can be different, depending on the company that provided the annuity and the cost.
The specifics of the rider will be written in the annuity contract. The insurance company determines the value of a contract on each anniversary of the annuity’s purchase. With a stepped-up death benefit rider, the beneficiary is paid the highest value amount recorded less any fees and withdrawals, instead of the value of the annuity when the insurance company learns of the annuitant’s death. Some insurance companies add a fee of 0.20 percent or more a year for this benefit.
For variable annuities, owners can pay for an additional rider. The insurance company takes the highest value of the asset for the month (as it changes with market fluctuations) and then pays benefits based on that value.
Death Benefits by Type of Annuity
Death benefits impact the total amount of money available for beneficiaries. The type of annuity — fixed, variable, immediate or deferred — determines how much the insurance company pays them.
There are general guidelines for determining the benefits of variable and fixed annuities. For most variable annuities, beneficiaries receive at least the original amount the owner contributed. For fixed annuities, the beneficiary receives the present value of payments.
For some immediate annuities, such as a lifetime immediate income annuity without term certain, the insurance company keeps the money when the owner dies. However, the annuitant can purchase a refund option or period certain rider and the beneficiary would receive any remaining payments.
For deferred annuities, the amount paid depends on whether the payments are in the accumulation or payout phase. Annuities in the accumulation phase pay beneficiaries the total amount contributed to the account. Once the annuity is in the payout phase, the beneficiary subtracts payments already made to the annuitant.
With the array of annuity options available and the customizable nature of contracts, the size of an inheritance greatly varies. Annuity owners can prepare for the future of a spouse or other beneficiary by comparing their options with an insurance expert.
Case Study Example
Here is an example of how someone might use an annuity to guarantee income for both them and their beneficiary.
Purchasing an annuity with a period certain rider is one way to leave income payments to a beneficiary while setting yourself up for guaranteed lifetime income.
“You’re defining a certain number of years of payments taking place,” said Stephen Kates, Annuity.org expert contributor and Certified Financial Planner™ professional. “If you outlive that, then you get lifetime payments. But if you don’t outlive that, your beneficiaries will receive the difference between how long you were alive and the end of that period.”
In the case study above, Vivian is looking for a way to turn her savings into guaranteed income for life. She also wants to leave some income for her beneficiary. By purchasing an annuity with 20-year period certain, Vivian can ensure that she’ll never run out of money, and her beneficiary is likely to receive payments after she passes away.
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What’s the Best Thing To Do with an Inherited Annuity?
For many beneficiaries, receiving an inheritance is an incredible blessing. However, it can be challenging to find yourself in this position, especially if you lack financial planning and investing experience. The last thing anyone wants to do is squander the money received from a loved one.
The best course of action for an inherited annuity depends on where you are in life, said Bill Ryze, a certified Chartered Financial Consultant (ChFC) and board advisor at Fiona.
If you’re not yet nearing retirement, Ryze suggested using the stretch provision, which allows beneficiaries to receive monthly, quarterly or annual payments based on their life expectancy.
For beneficiaries who are retired or at least 59 ½ years of age, Ryze said, “The wise thing to do when you inherit an annuity is to roll the annuity to an IRA because IRAs have more affordable fees and present alternative investment options.”
“When inheriting an annuity, the best thing to do is to speak with a financial advisor,” said independent life insurance agent Linda Chavez. “They will help you understand the different options available to you and make sure that you are making the best decision for your unique situation.”
A good advisor can help you establish a holistic plan that reflects consideration for your current financial position and future retirement needs. They can also help you implement an investment strategy that reflects your tolerance for risk, which is influenced by your time horizon, liquidity needs, tax position and legal situation.
As part of the process, the advisor will help you plan an optimal asset allocation, which will likely consist of some combination of stocks, bonds and alternative investments. Your strategy may also include annuities, which can provide a guaranteed stream of income in a relatively low-risk, hands-off manner.
Annuity Alternatives for Those Looking to Leave Money to a Beneficiary
Besides annuities, there are several other ways you can leave money to your heirs or beneficiaries. One of the most common alternatives for leaving money after you die is life insurance.
When you die, a life insurance policy pays out a death benefit to the person you designate as a beneficiary. The value of the benefit depends on the type of policy you purchase and how much you’re willing to pay in premiums.
You can also establish accounts to transfer money to your heirs without having to go through the execution of a will. The two most popular forms of these accounts are trust funds, which can hold assets such as investment accounts or real estate, and payable-on-death accounts, which are bank accounts that automatically transfer ownership to the beneficiary when the original owner passes.
Finally, your retirement account likely offers you the option to designate a beneficiary. Most retirement plans have a transfer-on-death designation that pays out the remainder of the account either in a lump sum or an annuity.
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Frequently Asked Questions About Inherited Annuities
Annuity owners may have the option to add a death-benefit provision to their annuity contract so their beneficiaries will receive a payout.
If no beneficiary is named, the payout of an annuity’s death benefit goes to the estate of the annuity holder, according to Chavez. It then becomes the estate’s responsibility to distribute the funds through probate.
If the annuity owner has designated a beneficiary, the contract’s value can pass to that beneficiary without going through probate.
Taxation of death benefits depends on the annuity type and setup. Inherited annuities are typically taxed as ordinary income. They are subject to income tax on withdrawals. Qualified annuities in retirement accounts may be taxed. Non-qualified annuities outside retirement accounts may face income or estate taxes.
If you believe that the annuitant’s choice of beneficiary shouldn’t be honored due to undue influence or possible fraud, you can contest in a court of law, according to Bill Ryze, ChFC.
You can sell an inherited annuity, and you’ll have the option of selling the entire annuity or selling only a portion of your annuity payments.
If the annuitant dies before the contract annuitizes, the beneficiary will receive the contract’s value either as a lump sum or as a series of payments.
A straight life annuity is one that ceases all payments when the annuitant dies.
If you inherited an annuity from a loved one, you likely need to complete an annuity beneficiary claim form to receive your inheritance.
Each state has its own rules. Typically, lottery winners may choose a beneficiary to receive the remaining lottery payments. Most states allow only one beneficiary.