Do Annuities Have Death Benefits? How They Work

Annuities are financial products designed to provide a steady stream of income, often utilized during retirement. While their primary function is to offer guaranteed payments to the annuitant, many annuity contracts also include a feature known as a death benefit. This provision ensures that a portion of the annuity’s value can be passed on to designated heirs upon the annuitant’s passing. The inclusion of a death benefit can be a significant consideration for individuals planning their financial legacy, offering a layer of financial protection for loved ones.

Annuity Death Benefits Explained

An annuity death benefit protects assets within the contract, ensuring funds are distributed to beneficiaries if the annuitant dies before exhausting the annuity’s value. It can be triggered at different stages of an annuity’s lifecycle.

During the accumulation phase, before income payments begin, the death benefit consists of the annuity’s contract value or the total premiums paid, whichever is greater. If the annuitant dies during this phase, beneficiaries receive this specified value. In the annuitization phase, after income payments commence, the death benefit’s availability depends on the specific payout option chosen. For instance, an annuity structured for a “period certain” continues payments to beneficiaries for the remainder of that guaranteed period, even if the annuitant dies sooner. The annuity contract outlines how the death benefit is calculated and under what conditions it applies.

Common Death Benefit Structures

Annuity contracts offer various death benefit structures, providing different levels of protection and often incurring distinct costs. A standard death benefit pays the beneficiary a fixed sum or the current contract value. This is the most basic option and may be included without additional charges.

Another common structure is the Return of Premium death benefit, guaranteeing beneficiaries receive at least the total premiums paid into the annuity, minus any withdrawals. This protects the initial investment, even if the annuity’s market value declines. Some annuities feature a Stepped-Up Death Benefit, periodically reset to the highest account value reached on certain contract anniversaries, increasing the payout to beneficiaries even if the annuity’s value subsequently declines. Enhanced death benefit riders are optional additions that provide more robust guarantees, such as a guaranteed minimum accumulation benefit or a death benefit component within a guaranteed minimum withdrawal benefit. These riders come with an additional annual fee, ranging from approximately 0.05% to 0.50% of the annuity’s value.

Designating Beneficiaries and Receiving Payouts

Designating beneficiaries is important for ensuring an annuity’s death benefit is distributed according to the owner’s wishes. Owners can name primary beneficiaries, first in line to receive the benefit, and contingent beneficiaries, who receive the benefit if all primary beneficiaries are deceased or cannot be located. Updating beneficiary information regularly is important, especially after significant life events like marriage, divorce, or the birth of children, to prevent unintended outcomes. If no beneficiary is named, the annuity assets may be subject to probate, a lengthy and costly legal process, or could even revert to the insurance company.

When an annuitant dies, beneficiaries have several options for receiving the death benefit. One common choice is a lump-sum payment, where the entire remaining value is paid out at once. Alternatively, beneficiaries can elect to annuitize the death benefit, receiving payments over time based on their own life expectancy; this “stretch” option allows the tax burden to be spread out over many years. For non-qualified annuities, if the beneficiary does not choose annuitization, the “five-year rule” applies, requiring the entire balance to be withdrawn within five years of the original owner’s death. Claiming a death benefit involves notifying the annuity company and submitting required documentation, such as a death certificate and claim forms.

Taxation of Annuity Death Benefits

Taxation of annuity death benefits depends on whether the annuity is qualified or non-qualified. Non-qualified annuities are purchased with after-tax dollars; the original premium (cost basis) is received tax-free by the beneficiary. However, any portion representing earnings or growth above the original premium is taxable as ordinary income to the beneficiary. If a lump sum is chosen, the entire earnings portion becomes taxable in the year of receipt, which could push the beneficiary into a higher tax bracket.

In contrast, qualified annuities, such as those held within an Individual Retirement Account (IRA) or 401(k), are funded with pre-tax dollars. The entire death benefit from a qualified annuity is taxable as ordinary income to the beneficiary, as original contributions were not previously taxed. Unlike inherited assets like real estate or stocks, annuities do not receive a “step-up in basis” at the owner’s death, meaning the cost basis for tax purposes does not adjust to the market value at the time of death. Spousal beneficiaries have unique tax advantages, including the option to roll over the inherited annuity into their own name, deferring taxes until they begin withdrawals. This spousal continuation allows the annuity to maintain its tax-deferred status.