What Happens to an Annuity When You Die?

An annuity functions as a contract with an insurance company, designed to offer a consistent income stream, often during retirement. It involves payments to an insurer, either as a lump sum or a series of contributions, in exchange for regular disbursements that can begin immediately or at a future date. These financial products serve as a tool for retirement planning. Understanding how an annuity’s value or payments are handled upon the death of its owner or annuitant is important for beneficiaries and estate planning.

Who Receives the Annuity Proceeds

When an annuity owner passes away, the proceeds are directed to the beneficiaries named in the contract. Designating both primary and contingent beneficiaries ensures the annuity’s value is distributed according to the owner’s wishes and avoids complications. A primary beneficiary is the first to receive the death benefit, while a contingent beneficiary acts as a backup, inheriting the annuity if the primary beneficiary cannot.

Failing to name a beneficiary, or if all named beneficiaries predecease the owner, can lead to the annuity’s value becoming part of the deceased’s probate estate. Probate is a legal process that validates a will and distributes assets, which can be time-consuming, costly, and potentially result in a distribution different from the owner’s original intent. Assets passing through probate are subject to state laws and may incur additional fees and delays before reaching the rightful heirs.

The roles of the annuity owner and the annuitant are distinct and affect how death benefits are handled. The owner purchases the annuity, controls the contract, and designates beneficiaries. The annuitant is the person whose life expectancy determines the payment schedule; often, the owner and annuitant are the same. If the annuitant dies but the owner is still alive, the owner can name a new annuitant, and the contract may continue without triggering a death benefit. However, the death benefit is typically paid upon the death of the annuity owner.

Differences exist in the treatment of spousal versus non-spousal beneficiaries. A surviving spouse often has more flexible options, such as continuing the annuity contract in their own name, preserving its tax-deferred status. This option, known as spousal continuation, allows the spouse to assume ownership and receive payments as if they were the original owner. Non-spousal beneficiaries generally cannot continue the annuity in the same manner and typically face more restrictive payout choices and immediate tax considerations.

Beneficiary Payout Choices

Beneficiaries inheriting an annuity have several choices for receiving the death benefit, each with different financial and tax implications. One common option is a lump-sum distribution, where the beneficiary receives the entire remaining value in a single payment. While this provides immediate access to funds, it can result in a substantial tax liability, as the entire taxable portion becomes due in the year of receipt.

Another option involves receiving payments over time, often called a “stretch” option or annuitization over the beneficiary’s life expectancy. This allows the beneficiary to spread out the tax burden over multiple years, potentially reducing the overall tax impact. For eligible beneficiaries, such as a surviving spouse, minor child, disabled or chronically ill individual, or an individual not more than 10 years younger than the deceased, the stretch option allows distributions over their own life expectancy. This can maximize the tax-deferred growth of the annuity.

For non-eligible beneficiaries, the SECURE Act altered payout rules. These beneficiaries are subject to the “10-year rule,” which mandates that the entire inherited annuity must be distributed by the end of the tenth calendar year following the original owner’s death. This rule applies to annuities held within inherited IRAs. While there are no required minimum distributions (RMDs) within this 10-year period, the entire account must be emptied by the deadline.

The “5-year rule” is another distribution option, primarily for non-qualified annuities and certain other scenarios. Under this rule, the beneficiary must withdraw the entire value within five years of the annuitant’s death. While there are no annual distribution requirements, the full amount must be withdrawn by the end of the five-year period. The applicability of the 5-year or 10-year rule depends on the annuity type, owner’s death date, and beneficiary’s relationship to the deceased.

Spousal continuation offers advantages for a surviving spouse. Instead of a lump sum or being subject to the 5- or 10-year rules, a spouse can elect to become the new owner of the annuity contract. This allows the annuity to continue growing tax-deferred, potentially until the spouse’s own death, at which point new beneficiary rules would apply. Spousal continuation can also involve rolling the inherited annuity into the spouse’s own Individual Retirement Account (IRA), if applicable, further deferring taxation. The specific type of annuity, whether immediate or deferred, fixed or variable, can also influence the available payout options and any associated death benefit riders, which may guarantee a minimum payout to beneficiaries.

Tax Considerations for Beneficiaries

The taxation of inherited annuities varies based on whether the annuity was “qualified” or “non-qualified.” A qualified annuity is purchased with pre-tax dollars within a retirement account, such as an IRA or 401(k). For these annuities, all distributions received by the beneficiary, including contributions and earnings, are taxed as ordinary income because the original contributions were not taxed. This means the entire death benefit from a qualified annuity is subject to income tax.

In contrast, a non-qualified annuity is funded with after-tax dollars. For these annuities, only the “gain” or earnings portion is subject to ordinary income tax for the beneficiary. The original principal, or cost basis, is received tax-free. This distinction is important because it means beneficiaries of non-qualified annuities do not pay tax on the money that was initially invested.

When payments from a non-qualified annuity are received as a series of distributions rather than a lump sum, an “exclusion ratio” is applied. This ratio determines the portion of each payment that represents a return of the tax-free principal and the portion that is taxable earnings. The exclusion ratio is calculated by dividing the original investment (cost basis) by the total expected return from the annuity. This mechanism helps spread the tax liability over the payment period, making each distribution partially taxable and partially tax-free until the entire principal has been recovered.

While the income tax liability falls on the beneficiary, an annuity’s value is generally included in the deceased’s gross estate for federal estate tax purposes. Federal estate tax applies only to very large estates, with exemption amounts that can change annually. For example, in recent years, the federal estate tax exemption has been over $13 million per individual.

Even if an annuity is included in the gross estate, the income tax liability on the growth is a separate consideration for the beneficiary. The choice of payout option, such as a lump sum versus payments stretched over time, directly impacts the timing of when the taxable income is recognized. A lump sum accelerates the tax liability into one year, potentially pushing the beneficiary into a higher tax bracket, while spreading payments over several years can mitigate this effect.

Steps to Claiming an Annuity Death Benefit

Claiming an annuity death benefit involves a structured process that beneficiaries must follow to receive the inherited funds. The initial step is to notify the annuity issuer, typically an insurance company, about the death of the annuity owner. This notification initiates the claims process. It is helpful to have the annuity contract number and the deceased owner’s information available when making this contact.

Following notification, the insurance company will provide the necessary claim forms and required documentation. Common documents include a certified copy of the death certificate, proof of the beneficiary’s identity (such as a driver’s license or state ID), and the completed annuity claim form. In some cases, additional paperwork may be requested, such as a copy of the deceased’s will or trust documents, especially if a trust is named as the beneficiary or if there are questions about beneficiary designations.

Once all required documentation is submitted, the annuity issuer will review the claim. The timeline for processing claims can vary depending on the completeness of the documentation, the complexity of the annuity contract, and the insurance company’s internal procedures. Beneficiaries can expect the initial review to take a few days to a couple of weeks, with full processing and disbursement potentially taking anywhere from a few weeks to several months. Maintaining open communication with the annuity company’s claims department can help ensure a smoother process.