Annuities can offer steady income in retirement. But what happens when the person who owns the annuity passes away? How are annuities taxed at death?
That’s a question many families face, often while dealing with a lot of other stress. Knowing how annuities are taxed at death can help you prepare, reduce confusion, and avoid surprise tax bills.
Taxes depend on the type of annuity, how you fund it, and how it’s set up to pay out after death. Understanding the rules makes a big difference.
What Happens to an Annuity After Death?
Wondering what happens to an annuity after death? The insurance company checks the contract to see what happens next.
Most annuities let the owner name one or more beneficiaries. If that’s in place, the money doesn’t go through probate. It goes straight to the people named.
Here’s what usually happens:
- The insurance company gets a copy of the death certificate
- They verify who the beneficiary is
- The beneficiary chooses how they want the money paid out
If the annuity was set up to pay income for life, payments stop at death unless there’s a joint owner or a guaranteed period. In that case, payments may continue for a set time or go to a surviving spouse.
If no beneficiary is listed, or if the beneficiary has also passed, the annuity goes to the estate and may get tied up in probate. That can mean delays and extra costs.
Ownership matters too. If a trust owns the annuity, the rules change. Taxes may also hit harder depending on who the beneficiary is: a spouse, child, or a trust.
Types of Annuities and Their Tax Implications
How annuities are taxed after death depends on the type of annuity and how you fund it. Each kind works differently, and that affects how much tax a beneficiary might owe.
Fixed Annuities
These offer guaranteed returns and less risk. Tax rules are straightforward:
- The IRS taxes the earnings portion as income.
- The principal (the original amount invested) is not taxed again.
Variable Annuities
These depend on how the market performs. They carry more risk but also more growth potential. If there's a variable annuity death benefit:
- Earnings grow tax-deferred but the IRS taxes it as income when paid out.
- A guaranteed death benefit may pay more than the current value, but the extra amount is also taxable.
Qualified vs Non-Qualified Annuities
The way an annuity was funded changes how it’s taxed.
- Qualified annuities are bought with pre-tax money (like in an IRA). The entire payout is taxed as ordinary income.
- Non-qualified annuities are funded with after-tax dollars. Only the earnings are taxed when paid out.
Variable Annuity Death Benefit: How It Works
A variable annuity can grow over time, but it also comes with a built-in death benefit. This guarantees a minimum payout to your beneficiary, even if the market goes down.
When the annuity owner dies, the insurance company pays the death benefit based on contract terms.
Here’s what a variable annuity death benefit usually includes:
- A basic death benefit that pays the greater of the account value or the total contributions (minus withdrawals)
- Some contracts offer a stepped-up benefit that locks in gains each year
- Others offer an enhanced death benefit that may increase the payout based on age or time held
These benefits help protect your beneficiary if the market drops. But they can also increase fees during the life of the contract. Payouts from a variable annuity death benefit are taxed as income, but only the earnings part. The original investment isn’t taxed again.
Annuity Death Benefit Payout Options
When a beneficiary inherits an annuity, they usually get to choose how they receive the money. Each death benefit payout option comes with different tax rules and long-term effects.
Here are the most common options for an annuity payout after death:
- Lump Sum: The full amount is paid at once. This option is simple but can create a large tax bill in one year, especially if there are a lot of earnings.
- Annuitization: This turns your money into a stream of payments. These can last for a set number of years or even for life. Each payment includes part earnings (taxable) and part return of principal (not taxed).
- Stretch Option (if available): This lets non-spouse beneficiaries stretch payments and taxes over their life expectancy. It’s not as common now due to changes in tax law (SECURE Act), but some older contracts still allow it.
- Spousal Continuation: A spouse beneficiary can often continue the contract as their own. It avoids taxes until they take withdrawals.
Annuity Death Benefit Tax Treatment
The IRS taxes annuity death benefits as ordinary income, but only the earnings part. The annuity death benefit tax treatment depends on how the annuity was set up and how the beneficiary takes the money.
Here’s how it breaks down:
- If the annuity was non-qualified, only the growth is taxable. The rest—the money originally invested—is tax-free.
- If it was qualified (like inside an IRA), the entire payout is taxable because no taxes were paid upfront.
The method of annuity payout after death also affects how taxes apply:
- Lump sum payouts often trigger the biggest tax hit because all the taxable income comes in one year.
- Annuitized payments spread the tax burden over time, combining taxable and non-taxable parts in each payment.
- If a spouse continues the annuity, taxes can be delayed until withdrawals begin.
Annuity companies usually issue a 1099-R form to show how much of the payout is taxable.
Who Pays the Taxes and When?
The person who receives the annuity death benefit pays the taxes. That’s usually the named beneficiary. If no one was named, the annuity goes to the estate, and taxes may be handled differently, and often less favorably.
Here’s what to know about timing and tax responsibility:
- Beneficiaries pay income tax on the taxable portion of the annuity payout. This applies whether it’s a lump sum or a stream of payments.
- Taxes are due in the year the money is received. If the payout is spread over years, taxes are too.
- The annuity company sends a 1099-R form to the beneficiary showing the taxable amount.
There are no early withdrawal penalties, even if the beneficiary is under age 59½. Those penalties only apply to the original owner.
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Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
Any comments regarding safe and secure investments and guaranteed income streams refer only to fixed insurance products. They do not in any way refer to investment advisory products. Rates and guarantees provided by insurance products and annuities are subject to the financial strength of the issuing insurance company; not guaranteed by any bank or the FDIC.
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