Tax Handling of Inherited Annuity Payments

by Gregory Gambone

Owning an annuity can provide financial advantages for you and your heirs both before and after your death. Annuities are retirement investment vehicles created and maintained by life insurance companies. This fact allows annuity contracts to offer benefits not available in other retirement accounts, most particularly life insurance options. You should familiarize yourself with the potential income tax consequences to your heirs so you can properly plan for the economic ramifications if they inherit your annuity.

Annuity Death Benefits

Annuity policies contain death benefit provisions allowing the contract owner to specify how, to whom and in what manner the account value will be distributed in the event of his death. Since annuities are issued by life insurance companies, special death benefit features may be added that remain unavailable with other types of retirement accounts. Not all annuity carriers offer the same death benefit provisions, and some options may be more attractive than others.

Non-Spousal Beneficiary

If the beneficiary of an annuity is anyone other than the owner's spouse, the death benefits are automatically considered additional income. Beneficiaries may opt to take the account value as a single lump sum or a stream of regular payments over the course of five years. Any proceeds received are added to the beneficiary's taxable earnings for that year. Edward Jones explains that annuity death benefits avoid probate, but the value of the policy "also will be included in your estate for estate tax purposes."

Spousal Beneficiary

If an annuity owner lists his spouse as beneficiary, the same tax rules and regulations apply to receipt of death benefit proceeds. However, one additional option is available only to spouses - continuation of the policy. Upon the death of the original owner, spouses may elect to maintain the annuity contract and simply re-title the account into their own name. This choice does not create a taxable event and all taxes will become due when the spouse eventually begins taking distributions. ImmediateAnnuities.com explains, "(the spouse) can elect to have the retirement benefits treated as her own for purposes of determining the tax on excess retirement distributions during life and on excess retirement accumulations at death under Code Sec. 4980A."

Death After Annuitization

If an annuity owner dies after already initiating annuitization, the remaining proceeds will be distributed to beneficiaries per the provisions of the contract, and money paid to heirs will be added to that year's taxable earnings regardless of their relationship to the owner. Annuitization options include life only, period certain, or life with period certain. Owners choosing life only receive guaranteed monthly payments until their death, regardless of the actual sum total of payouts. However, at death those payments cease even if the aggregate sum paid is less than the contract value at the time of annuitization. Owners who choose a period certain option receive money for a specified number of years, and if death occurs before the end of the guaranteed period any remaining balance gets distributed to heirs.

About the Author

Gregory Gambone is senior vice president of a small New Jersey insurance brokerage. His expertise is insurance and employee benefits. He has been writing since 1997. Gambone released his first book, "Financial Planning Basics," in 2007 and continues to work on his next industry publication. He earned a Bachelor of Science in psychology from Fairleigh Dickinson University.

Photo Credits

  • Stockbyte/Stockbyte/Getty Images