What Happens at the End of an Annuity Contract?

Annuities are long-term financial products designed to provide a steady income stream, especially during retirement. They are a contract between an individual and an insurance company, where payments are made in return for regular disbursements at a later date. Annuities help accumulate funds on a tax-deferred basis and convert savings into predictable income, mitigating the risk of outliving financial resources.

The Contract’s Conclusion Points

An annuity contract concludes its accumulation phase or active period through several scenarios. One common trigger is reaching a predetermined maturity date specified in the contract, at which point the annuity owner can begin receiving payouts.

Another way an annuity contract concludes is through a surrender or significant withdrawal by the owner. An owner might choose to surrender the entire contract before its maturity date, receiving its cash surrender value, though this often incurs surrender charges. Partial withdrawals can also be made, which reduce the contract’s value and can affect future payouts. The death of the annuity owner or annuitant also serves as a conclusion point, activating specific provisions for beneficiaries.

Annuitization Payout Choices

Annuitization is the process of converting an annuity’s accumulated value into a stream of regular income payments. This decision is irrevocable; the chosen payout structure cannot be changed once payments begin. Annuitization provides a reliable income flow, often for life.

Several income stream options are available upon annuitization.
Life Only: Provides payments for the annuitant’s lifetime. Payments cease upon death, with no remaining value passed to beneficiaries.
Life with Period Certain: Guarantees payments for the annuitant’s life and for a specified minimum period (e.g., 10 or 20 years). If the annuitant dies before the period ends, payments continue to a beneficiary for the remainder of that period.
Joint and Survivor: Provides payments for the lives of two individuals, typically spouses, ensuring income continues for the surviving partner after the first annuitant’s death. This option usually results in lower individual payments compared to a “Life Only” option because payments are expected to last for a longer combined duration.
Fixed Period: Provides payments for a specific number of years, regardless of life expectancy. If the annuitant dies before the period ends, remaining payments go to a beneficiary.

Lump Sum Distributions

A lump sum distribution means receiving the entire accumulated value of an annuity in a single payment. This option provides immediate and full access to funds, offering liquidity that annuitization does not, and effectively closes the annuity contract.

While a lump sum provides immediate access to capital, it also carries considerations. A primary benefit is having immediate control over the entire sum, which can be useful for large expenses or other investment opportunities. However, this choice forfeits the guaranteed income stream that annuitization provides and can create a substantial tax liability in the year of distribution.

Partial withdrawals involve taking out a portion of the annuity’s value while keeping the contract active and allowing remaining funds to grow. A lump sum, by contrast, liquidates the entire contract.

Tax Considerations for Distributions

Distributions from annuity contracts carry specific tax implications, whether received as annuitized income, a lump sum, or partial withdrawals. Annuity earnings grow tax-deferred, with taxes typically not owed until funds are withdrawn. When distributions begin, the earnings portion is taxed as ordinary income.

For non-qualified annuities, funded with after-tax dollars, only the earnings are taxed upon withdrawal. The “last-in, first-out” (LIFO) rule applies to non-qualified annuity withdrawals, meaning earnings are distributed first and are fully taxable until all accumulated gains have been withdrawn. Once earnings are exhausted, subsequent withdrawals represent a return of the original, already-taxed principal and are tax-free. For annuitized payments from non-qualified annuities, an “exclusion ratio” determines the portion of each payment that is a tax-free return of principal versus taxable earnings.

A 10% IRS penalty tax applies to the taxable portion of withdrawals made before age 59½, unless a specific exception applies. Qualified annuities, funded with pre-tax dollars (e.g., within a 401(k) or IRA), have different tax treatment; the entire distribution, including both contributions and earnings, is taxed as ordinary income upon withdrawal because no taxes were paid on the original contributions.

Beneficiary Payouts

Annuity contracts include a death benefit provision, passing any remaining value to named beneficiaries upon the death of the owner or annuitant. Options for beneficiaries vary based on their relationship to the deceased and the annuity type.

Spousal beneficiaries often have more flexibility, including the option to continue the contract as the new owner, maintaining its tax-deferred status. Non-spousal beneficiaries have different options, such as taking a lump sum, which is immediately taxable on the earnings portion.

A common option for non-spousal beneficiaries, especially for non-qualified annuities, is the “stretch” option. This allows the beneficiary to receive payments over their own life expectancy, spreading out tax liability over a longer period and potentially allowing for continued tax-deferred growth of the remaining funds. Alternatively, some contracts may impose a “5-year rule,” requiring the entire annuity value to be distributed within five years of the owner’s death, which can accelerate tax obligations.