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What Happens to an Annuity When You Die?

An annuity is a financial instrument that accrues interest on a tax-deferred basis and protects against market risk and longevity risk. Because annuities offer many benefits, lottery winners, retirees and structured settlement recipients use them to create predictable cash flow for the present, future and even after their death.

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 provision 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 insurance companies to create custom contracts that specify payout and beneficiary options. After an annuitant dies, insurance companies distribute any remaining payments to beneficiaries in a lump sum or stream of payments. It’s important to include a beneficiary in the annuity contract terms so that the accumulated assets are not surrendered to a financial institution if the owner dies.

Similar to setting up a life insurance policy, owners can customize their annuity contract 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 inclusion of the death benefit clause.

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Inherited Annuity Payout Options

Beneficiaries inheriting an annuity typically have three options for how to receive annuity payments after the contract owner’s death.

Beneficiary Payout Options
Lump-Sum Distribution
A lump-sum distribution allows the beneficiary to receive the entire remaining value of the contract in one payment.
Nonqualified-Stretch Provision
When a nonqualified-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.

Spousal beneficiaries have the option to continue with the initial contract as the new owner and annuitant.

Financial expert Juliette Fairley explains how your annuity will be handled if you pass away before receiving the full amount of it.

Annuitant vs. 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, designates beneficiaries, can sell the annuity and has automatic rights over the agreement. 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.

Pro Tip
Owners are often annuitants, and the annuity benefit payments are calculated based on the annuitant’s life expectancy.

A beneficiary is the 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.

Pro Tip
Beneficiaries can be people or organizations.

A list of beneficiaries ensures that the designated people and organizations receive the specified amount or percentage. Minors designated as beneficiaries can’t access their inherited annuity until they reach the age of majority (18).

By designating a beneficiary in an annuity contract, owners also protect heirs from probate, the legal process of distributing a deceased person’s estate.

Probate is costly and time consuming. 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.

Owners can also assign a trust to receive any remaining payments. However, because payments going to trusts are not based on life expectancy (as they are when payments are transferred to a beneficiary), the money must be paid out within five years.

Spouse vs. Non-Spouse 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.

Inherited Annuity Tax

People inheriting an annuity owe income tax on the difference between the principal paid into the annuity and the value of the annuity at the annuitant’s death. How taxes are paid on an inherited annuity will depend on the payout structure selected and the status of the beneficiary. If they choose a lump sum, beneficiaries must pay owed taxes immediately.

The tax situation for the beneficiary is similar to that of the annuitant, in that taxes are not owed until the money is withdrawn from the annuity.

Are Inherited Annuities Taxable?

Inherited annuities are taxable as income. The beneficiary of a tax-deferred annuity may choose from several payout options, which will determine how the income benefit will be taxed.

If the beneficiary is the spouse of the annuitant, 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 is the option with 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 the 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.

The option with the lowest tax exposure is to have the death benefits paid over the life expectancy of the beneficiary. This means that benefits will be paid out over a longer period of time.

Reporting Inherited Annuity Income to the Government

Inherited annuity income should be reported to the Internal Revenue Service, 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 percent 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. In the case of 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 at 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.

Additional Riders

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 for 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 a 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.

Can You Inherit a Lottery Annuity?

If a Powerball or other lottery winner chooses to take the prize as an annuity over 30 years and dies before the 30 years have passed, what happens to the annuity?

The payments will continue until the end of the 30 years as determined by the lottery winner.

Each state has its own rules, but typically, lottery winners may choose a beneficiary to receive the remaining lottery payments. Most states allow only one beneficiary. If this is the case in your state and you wish to leave the money to more than one heir, you could have the lottery payments made to your estate for distribution to your heirs.

Just as the lottery winner would have to report the prize to the government and pay taxes, so, too, would your estate and any heirs who inherit the lottery winnings.

Please seek the advice of a qualified professional before making financial decisions.
Last Modified: August 30, 2021

8 Cited Research Articles

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