Death Benefit Taxation

When an annuity owner dies, the tax treatment of the death benefit depends on several factors, including the relationship of the beneficiary and the distribution option chosen.

Key Difference from Life Insurance

Critical Distinction:

• Life insurance death benefits: Generally income tax-free
• Annuity death benefits: Generally income taxable on the gain

Exam Tip: This is a frequently tested concept. Remember that annuity death benefits do NOT receive the same tax-free treatment as life insurance.

Taxation to Beneficiaries

When the annuity owner dies, the beneficiary must pay income tax on the gain portion of the death benefit.

Taxable Amount = Death Benefit Value - Decedent's Cost Basis

Example: Non-Qualified Annuity Death Benefit

Annuity Facts:

• Death benefit value: $300,000
• Original investment (basis): $150,000
• Gain: $150,000

Tax Consequence:

• Beneficiary receives: $300,000
• Taxable ordinary income: $150,000
• Basis received tax-free: $150,000

No Step-Up in Basis

Unlike most inherited assets, annuities do NOT receive a step-up in basis at death:

This is a significant disadvantage of annuities for wealth transfer purposes.

Distribution Options for Beneficiaries

Beneficiaries have several options for receiving the death benefit, each with different tax implications:

Non-Spouse Beneficiary Options

SECURE Act Changes

The SECURE Act (2020) eliminated the "stretch" option for most non-spouse beneficiaries:

Key Point: Most non-spouse beneficiaries must now fully distribute the inherited annuity within 10 years of the owner's death.

Spousal Continuation

Surviving spouses have unique options:

Option 1: Spousal Continuation

The spouse can continue the annuity as their own:

• No immediate taxation
• Tax deferral continues
• RMDs apply when spouse reaches age 73
• Spouse can name new beneficiaries

Option 2: Lump Sum Distribution

• Receive full death benefit immediately
• Pay income tax on all gains in current year
• May push spouse into higher tax bracket

Option 3: Annuitize Over Life

• Convert to lifetime income stream
• Use exclusion ratio for taxation
• Spread taxes over remaining life expectancy

Inherited Qualified Annuities

For annuities held in qualified accounts (IRA, 401(k)):

Qualified Annuity Death Benefit Example

401(k) Annuity Facts:

• Death benefit: $500,000
• Cost basis: $0 (all pre-tax contributions)
• Beneficiary: Adult child (non-spouse)

Tax Consequence:

• Must distribute within 10 years
• Full $500,000 taxable as ordinary income
• Beneficiary decides when to take distributions within 10-year window

Estate Tax Considerations

While the death benefit is subject to income tax, it may also be subject to estate tax:

Income in Respect of a Decedent (IRD)

Annuity death benefits are Income in Respect of a Decedent (IRD):

• Taxable income that the decedent had a right to receive
• No step-up in basis available
• Beneficiary may claim itemized deduction for estate tax attributable to IRD

Planning Considerations

Summary: Annuity vs. Life Insurance Death Benefits