Understanding Annuity Death Benefits
If you’ve taken out an annuity with a contractual clause covering death benefits, there are important tax implications you need to know about that might adversely affect your beneficiaries. Annuities are one of the three primary instruments people take out when considering their legacy, the other two being life insurance and a pension. Of the three, life insurance is the only one where the heir generally does not pay tax on the sum received. Annuity death benefits are generally fully taxable to surviving heirs.
The details of annuity death benefits are contractually agreed upon at the start of the annuity contract. The type of annuity and the method of payout will both affect the potential tax burden on the beneficiary. Unfortunately, the number of combinations available for types of annuities and payouts has grown incredibly, adding confusion to an already contentious subject. But here are the main points to understand.
Broadly speaking, there are two types of annuities—fixed annuities and variable annuities.
In a fixed annuity, the “annuitant”—the person who took out the annuity—receives a fixed interest rate for the amount they have paid into the annuity account so far. They receive this interest while still paying premiums into the annuity. This is called the accumulation phase. In a variable annuity, the annuitant receives a variable interest rate depending on the performance of underlying investments. After the annuity is paid up, the payout phase (also known as the “annuitization” phase) can either commence immediately—called an immediate annuity—or it can commence at a later date—a deferred annuity.
The type of annuity selected affects how much the beneficiary receives. Generally speaking, most variable annuities pay out the amount originally paid into the account to beneficiaries. Fixed annuities generally pay out the present value of payments unless modified by riders in the contract.
As mentioned above, there are a plethora of mix-and-match combinations for annuity contracts, and the following is just a general guide. Each contract can be tweaked individually, and you should consider consulting with an experienced annuity lawyer to ensure you are getting the best deal.
The fixed-period or period-certain payout option guarantees payment to the annuitant for a set number of years such as 10, 15, or 20. For beneficiaries to receive annuity death benefits, these must be specified in the original contract. Payments to beneficiaries occur only if the fixed period has not yet elapsed or if there is still a balance left on the account.
The life payout option guarantees an income stream to the annuitant for the rest of his or her life. The period of the payout is unknown, bringing some risk to the insurer, but the payout amount is known and determined at the start of the payout phase. This amount will depend on (1) the expected lifespan of the annuitant, (2) the amount in the account. If the annuitant passes away during the accumulation phase, there is generally an annuity death benefit equal to the sum of the premiums paid, or the total value remaining in the account, whichever is greater.
There is no annuity death benefit in the payout phase for this payout option.
This is the same as the life payout option but payments continue until the annuitant’s spouse dies, so there is an annuity death benefit for the spouse. If both partners die early, there is sometimes a contractual clause that allows for annuity death benefits to a third beneficiary.
This option provides a balance of lifetime payments but also annuity death benefits for a beneficiary if the annuitant dies within a certain time period. For example, let’s say the period-certain is set to 15 years. The annuitant will actually receive payments for life but if he or she dies within that 15-year period, a beneficiary can be named to receive the payouts until the 15-year period is at an end.
Annuities are tax-deferred investments, meaning that they are taxed at the time of payout, not at the time of payment. Annuity payments are taxed as regular income, not as capital gains, which puts higher-earning beneficiaries at an immediate disadvantage. Not only is capital gains tax lower than regular income tax, but the additional regular income from the annuity might push a beneficiary into a higher tax bracket, thereby shaving off more of the annuity’s payouts.
Perhaps one of the worst tax flaws of annuity death benefits is that many variable annuities don’t come under the “step-up in basis” tax readjustment clause.
A step-up in basis, sometimes called a Step-up in Cost Basis, refers to the adjustment of the cost basis of an asset so that the beneficiary isn’t saddled with a heavy tax burden as a result of the asset’s appreciation. To explain it simply: The “Cost Basis” of an asset is its original value for tax purposes and is used to calculate capital gains tax when that asset is sold. So, let’s say someone bought some stock in 1960 for $10 a share. In that person’s will, they hand down the stock to their grandson. When the grandson gets hold of the stock, it’s worth $100. The grandson’s Cost Basis will be $100, not $10, because of the step-up in basis which uses the cost basis of the share when the grandson received it, not when his grandfather originally purchased the stock. This way, the grandson won’t need to pay any capital gains tax on the $90 per share if he sold the stock immediately.
Most variable annuities do not qualify for step-ups in basis because they are taxed as normal income. Investing in assets that qualify for Step-Ups in Basis might be a better option than annuities, from the perspective of tax and death benefits.