Some insurance companies sell annuities that have a guaranteed death benefit. Other companies sell the death benefit as a separate rider. Either way, the death benefit is considered to be an important feature of an annuity. While some insurance companies structure the death benefit differently, it usually means that upon the annuitant’s death, the beneficiary will receive at minimum the amount of premiums paid by the annuitant. In other words, if the annuitant purchased an immediate fixed annuity for $100,000, his or her beneficiary will receive $100,000 upon his or her death.
Once the annuity is annuitized, however, the death benefit expires. Most insurance companies will also set an age at which the death benefit will expire. Typically, the age is 85. The death benefit then, can be considered as an insurance policy on an annuity. It ensures that the value of the contract will not go down if the owner dies before payments begin. Studies show that a very small percentage of annuities, fewer than 10%, actually pay the death benefit because most contracts are annuitized before the owner dies.
Many life insurance companies will pay even more to the beneficiary. The amount paid can be as high as 5% to 7% interest that is compounded annually, or, they will pay the value of the account on the preceding anniversary of the contract date, whichever is higher. For those who are concerned about dying early in the contract term and not receiving at least the amount of their premiums back in payouts, the death benefit is a secure option.
While an annuity with a death benefit will guarantee that money is returned to the beneficiary, it will be a more costly product. For example, depending on the insurance company and any other benefits that are attached to the annuity, this type of contract can cost anywhere from .05% to .50% more annually than an annuity without a death benefit.
How is an Annuity Death Benefit Taxed
In most states, a surviving spouse automatically becomes the owner of an annuity upon the death of the original owner if no other beneficiary has been named. The spouse simply becomes the new owner of the annuity and the funds within it continue to grow on a tax-deferred basis. Some insurance companies, however, will allow the spouse to choose whether or not he or she wishes to receive the death benefit or prefer that it be kept within the annuity. If he or she chooses to receive the death benefit, taxes will most likely be due on at least the portion that has increased in value. If he or she chooses to keep the death benefit within the annuity, the benefit is not taxable.
If, however, the beneficiary is a child or other relative of the deceased, the money within the annuity is taxable at regular rates. The beneficiary can choose to receive the benefit as one lump sum or as monthly payments over time. However, the value of the entire annuity will be considered part of the annuitant’s estate, and therefore, the beneficiary will also owe inheritance taxes.
An immediate annuity can be set up with single or joint ownership, meaning that one person can own it individually or a married couple can own it jointly. When the owner of a variable annuity dies, some companies allow the surviving spouse to continue the policy without any tax consequences. Some annuity companies will pay the death benefit directly into the policy, thereby avoiding the tax event for the spouse. However, a spouse who opts to receive the death benefit does trigger a taxable event.
The difference in the between the amount originally invested and the amount of the death benefit is taxed at his or her ordinary income tax rate. It is important to note that the gains earned on annuities are taxed as ordinary income, not at the capital gains rate as other investments are.
Additional Tax Considerations
Unlike all other qualified and non-qualified investments – equity and bond mutual funds, certificates of deposit and real estate – that are inherited by a non-spousal beneficiary, a deferred annuity does not qualify based on the “step-up basis” rule under United States federal tax law. The step-up basis allows the beneficiary to inherit an asset at its current fair market value rather than the decedent’s purchase price. This minimizes the capital gains taxes that will be due at the time the beneficiary sells the asset.
In other words, if the beneficiary inherits an equity fund at $25 per share for which the decedent paid $10 per share, and then he or she sells the equity at $30 per share, he or she can claim the basis cost of the stock as $25, not $10. The capital gains taxes due will then be the difference between $25 and $30, not $10 and $30. And, any deferred income from the annuity that is paid to the beneficiary is taxed at ordinary income levels. A non-spousal beneficiary is often advised to choose annual payments instead of a lump sum distribution in order to spread the ensuing tax liability over several years.
Naming an Alternate Beneficiary
The beneficiary of the death benefit does not have to be a spouse or relative. Some annuity owners designate a charity or favorite cause as the beneficiary. A medical organization such as St. Jude’s, an alma mater or a group that works with children are all fine choices. Naming a charity also helps with estate planning for those who wish to reduce the size of the taxable estate that is left for other heirs. Interestingly enough, pet owners who have established a pet trust can now name the pet trust as the beneficiary. This ensures that the decedent’s pet or pets are taken care of after his or her death. As with any investment, it’s always a good idea to meet with a certified financial or estate planner prior to purchasing an annuity and naming the beneficiary.