Do Variable Annuities Have Death Benefits?

A variable annuity is a contract between an individual and an insurance company, combining elements of insurance with investment features. It serves as a long-term savings vehicle, often utilized for retirement planning, allowing invested money to grow on a tax-deferred basis. A notable aspect of these financial products is that they can include a death benefit, which provides a financial safeguard for beneficiaries.

Understanding Variable Annuity Death Benefits

A variable annuity death benefit provides a guaranteed payout to designated beneficiaries upon the annuitant’s death. This ensures a specific amount is distributed, regardless of how underlying investment sub-accounts have performed. Its purpose is to protect beneficiaries from market declines that might otherwise reduce the contract’s value. If the account value falls below the guaranteed amount, the death benefit ensures beneficiaries receive at least the guaranteed sum.

While many variable annuities offer a death benefit, it is not an automatic inclusion in all contracts. These benefits come with specific terms and can incur additional costs. The standard death benefit typically guarantees that beneficiaries receive either the current contract value or the total amount of premiums paid into the annuity, minus any prior withdrawals, whichever amount is greater. The cost for this standard feature is embedded within the mortality and expense (M&E) charges of the annuity, which can range up to 2% of the contract value annually.

Types of Death Benefit Provisions

Variable annuities can incorporate various structures for their death benefit provisions, determining how the payout amount is calculated. The most straightforward is the standard death benefit, often referred to as “Return of Premium,” which ensures beneficiaries receive at least the total premiums contributed, reduced by any withdrawals made. This benefit acts as a capital preservation mechanism.

More robust options are available as optional riders, which come with additional fees, ranging from 0.5% to 1.5% of the contract value each year. The “Highest Anniversary Value” or “Stepped-Up Benefit” rider locks in the annuity’s account value at its highest point on certain anniversary dates, or other specified periods. This means if the market performs well, the death benefit base is reset upwards, providing beneficiaries with a higher guaranteed payout even if the market declines subsequently. An “Earnings Enhancement” death benefit may also be offered, which adds an additional percentage of the investment gains to the base death benefit amount.

Beneficiary Designation and Payout Options

Properly designating beneficiaries for a variable annuity ensures the death benefit is distributed according to the policyholder’s wishes. Policyholders name primary beneficiaries, who are the first in line to receive the benefit, and contingent beneficiaries, who would receive the benefit if all primary beneficiaries are deceased or unable to claim it. The annuity owner retains the right to change beneficiaries unless an irrevocable designation has been made.

Upon the annuitant’s death, beneficiaries have several options for how they can receive the death benefit. One common option is a lump sum payment, where the entire death benefit is paid out at once. Another option is annuitization, which converts the death benefit into a series of periodic payments over a set period or for the beneficiary’s lifetime. Additionally, a “stretch provision” is available, particularly for non-spouse beneficiaries, allowing them to stretch out payments over their life expectancy, which can help defer tax liabilities. Beneficiaries should carefully consider these payout options and benefit from consulting a financial advisor to understand the implications of each choice.

Taxation of Variable Annuity Death Benefits

The taxation of variable annuity death benefits is a consideration for beneficiaries. For non-qualified annuities, which are funded with after-tax dollars, only the earnings portion of the death benefit is subject to ordinary income tax. The original premiums paid into the annuity, representing the cost basis, are not taxed again because those funds were already taxed before being invested.

In contrast, qualified annuities, such as those held within an Individual Retirement Account (IRA), are funded with pre-tax dollars. For these annuities, the entire distribution of the death benefit is taxable as ordinary income to the beneficiary, as no taxes were paid on the contributions or earnings prior to distribution. Additionally, the value of the annuity can be included in the deceased annuitant’s estate for estate tax purposes, depending on the overall size of the estate. While Section 1035 of the Internal Revenue Code allows for tax-free exchanges of certain insurance products between living policyholders, this provision does not apply directly to death benefits.