An annuity is fundamentally different from a mutual fund, stock or other asset. Unlike these assets, which represent an ownership claim on an asset that can be easily passed from generation to generation, an annuity is a contract between the annuity owner and an insurance company to provide income. The contract is secured by the general account of the insurance company, and not by any special segregated account. You can pass on certain contractual rights to an annuity to the next generation -- this is governed by contract law, rather than by probate law. The annuity contract with the insurance company determines what the heirs will receive. You can pass some annuities on to heirs, but not others, depending on the terms of the annuity contract. The terms of the annuity contract also govern under what terms, if any, an annuity beneficiary can leave annuity assets to his or her heirs.
Immediate vs. Deferred Annuities
Annuities can be structured to provide immediate or current income, or the assets can be held in the general account of the insurance company with the promise of a stream of income commencing in a future year. It is generally a simple matter to pass a deferred annuity on to the next generation. Some deferred annuities, though, cannot be readily passed on, unless the insurance company's annuity contract specifically guarantees it.
Deferred Annuity Death Benefits
Many variable annuity contracts have an attractive feature called the guaranteed death benefit. This means that even though the value of the annuity contract rises and falls with market fortunes, the insurance company guarantees the annuity owner that in the event of his or her death, the insurance company will forward everything the annuity owner invested in the annuity over the years to the heir or heirs. The insurance company can do this because the annuity is backed by the general fund of the company, and not by a segregated asset. This benefit may go away, however, once the stream of income starts. However, some companies guarantee that heirs will receive any difference between what the recipient of an annuity stream of income withdraws and the amount invested.
Lifetime Income Annuities
Lifetime income annuities are immediate annuities that are guaranteed to pay out for the entire life of the annuitant, no matter how long that individual lives. If the annuity owner selects the "life only option," this maximizes monthly or annual income, but the heirs may receive nothing. All available proceeds go to subsidize other annuitants who live beyond life expectancy. This is why payout rates are higher than interest rates when you buy a lifetime income annuity. The same principle applies to any annuity that has been annuitized -- that is, that has commenced the distribution of a stream of income. Some annuities will guarantee, however, that the annuitant's heirs will receive any unspent contributions.
Some annuities offer a "period certain" guarantee, meaning that the insurance company is contractually obligated to pay out benefits for a specific period of time. You may also be able to choose a "life with period certain" guarantee. For example, a "life with 10 years certain" guarantee will pay income for the life of the annuitant, or for 10 years, whichever is longer.
Taxation of Inherited Annuities
If you receive an annuity via inheritance, the IRS will credit you for any contributions the deceased made with taxable dollars. That is, you will receive the decedent's "tax basis" back, tax free. However, any money received in excess of this figure will be taxed at ordinary income rates. The IRS charges income tax on any gains in the annuity. Your estate may also have to pay an estate tax on any annuity balances left behind for your children.
Some annuity contracts allow you to leave a stream of income, guaranteed for life, to a designated beneficiary who survives the original owner -- and then have a lump sum pass to a third generation. For example, a grandmother could purchase a lifetime income annuity with her own assets, naming her grand-daughter as the second to die heir. The insurance company will then pay a stream of income to the granddaughter for as long as she lives. When the granddaughter dies, the insurance company can pay a lump sum to a great grand-child. The income stream from this kind of annuity contract will be much lower than a life-only contract guaranteeing income only for the life of the grandmother, however.
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