Tax Consequences to the Annuity Beneficiary

Annuities are especially attractive to retirees because they assure an income for life. They’re often held as deferred annuities as a back up for those later retirement years as a supplement to other retirement income or when savings become depleted. But many retirees will die before tapping their deferred annuity. What are the tax consequences to the annuity beneficiary and should other options be arranged?

A deferred annuity offers a distinct tax-benefit. It’s earning grow tax-deferred. For the same annual return as a taxable investment, a tax-deferred investment compounds faster because none of the earnings are taxed away each year. However those tax-deferred earnings will eventually be taxed upon withdrawal, whether by you or the annuity beneficiary. Your contributions to the annuity, though, will not be taxed. This is the case in ‘nonqualified’ annuities which are funded with after tax contributions.

Annuitant’s taxation
If a partial withdrawal is made, the IRS presumes that earnings come out first – so that these are completely taxable. But under regular monthly payments – a portion of each payment is not taxed but treated as a return of your nontaxable contributions. An exclusion ratio calculated by the insurance company designates that untaxed portion. When, after some number of payments and you’ve received all your contributions, all future payments will be fully taxed as income.

Beneficiary taxation
After tax contributions made by the deceased owner will remain  untaxed when received by the beneficiary. And of course, all those tax-deferred earnings within the annuity will be taxed as ordinary income to the beneficiary.

Usually, if the annuitant had begun receiving lifetime payments, no benefits would be left for the annuity beneficiary. But if the contract called for a fixed term guaranteed payments, the beneficiary would received those remaining payments taxed at the deceased’s exclusion ratio.

If the annuity owner died before beginning annuitization, provision may be made for either a lump sum distribution or a series of payments. For the lump sum payment, the beneficiary would only pay tax on the earnings portion.

But in the case of a series of guaranteed payments, the beneficiary would not be required to pay taxes on any of the payments until the deceased owner’s contribution were fully received. Any payments beyond that would be fully taxed as ordinary income.

An annuity beneficiary, who earns a substantial income already, can lose a lot of that taxable portion of the annuity as he’s pushed into a high tax bracket. So, if annuity owner decides not to annuitize, he may use his annuity’s value to switch to another option better suited to his beneficiary.

Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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