Understanding Taxes on Annuity Death Benefits: What You Need to Know

Shawn Plummer

CEO, The Annuity Expert

Navigating the labyrinth of financial terms and regulations can often feel daunting. But, a clear understanding of annuities and their implications for beneficiaries is crucial. In this guide, we’ll break down the ins and outs of taxes on annuity death benefits, touching on both qualified and non-qualified annuities. You’ll be better equipped to make informed decisions and confidently provide for your loved ones.

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The Basics of Annuity Death Benefits

An annuity death benefit is paid to a beneficiary when the owner dies. While the concept seems straightforward, the tax implications vary depending on the type of annuity and its specifications.

Example: Suppose John has an annuity worth $200,000 when he passes away and hasn’t started receiving payments. His beneficiary, Sarah, will receive a death benefit. The tax implications for Sarah depend on the type of annuity John had.

Taxes On Annuity Death Benefits

Qualified Annuities: What Are They and How Are They Taxed?

Qualified annuities are tax-deferred retirement savings accounts regulated by the IRS. Contributions to these annuities are often pre-tax dollars, meaning you don’t pay taxes on the money you put in; instead, you’ll pay taxes when you withdraw the money.

Death Benefit Taxation

When a beneficiary receives a death benefit from a qualified annuity, they’re typically subject to ordinary income tax on any earnings above the original investment. They aren’t taxed on the original amount invested.

Example: If John invested $150,000 in a qualified annuity and it grew to $200,000, Sarah would only pay income tax on the $50,000 gain, not the entire $200,000.

Do You Pay Taxes On Annuity Death Benefit

Non-Qualified Annuities: Their Distinct Features and Tax Implications

Non-qualified annuities differ in that they’re funded with post-tax dollars. You’ve already paid taxes on the money you invest in these annuities, making their tax structure different from qualified annuities.

Death Benefit Taxation

Beneficiaries must pay taxes only on the earnings, not the principal, for non-qualified annuities. This mirrors the taxation for the annuity owner during their lifetime.

Example: If John invested $150,000 (post-tax) in a non-qualified annuity and it grew to $200,000, Sarah would again only be responsible for taxes on the $50,000 growth.

Tax On Annuity Death Benefit

Options for Beneficiaries

It’s not just about knowing the tax implications. Beneficiaries can choose how they’d like to receive the death benefit, whether as a lump sum, through systematic withdrawals, or by continuing the annuity contract.

Lump Sum

Beneficiaries can choose to take the entire death benefit amount at once. However, this might push them into a higher tax bracket for that year.

Example: Sarah decides to take the entire $200,000 at once. Depending on her income, this might elevate her into a higher tax tier, leading to a larger tax bill.

Systematic Withdrawals

Another option is to spread the withdrawals over time, offering potentially favorable tax treatment and more consistent income.

Example: Sarah chooses to withdraw $20,000 annually. This might help in managing her tax liability over the years.

Continuing the Annuity

Beneficiaries might also have the choice to continue the annuity, allowing it to grow and later draw an income from it.

Example: Instead of withdrawing, Sarah continues John’s annuity, letting it grow. She can start drawing an income when ready, offering her a steady financial resource.

Taxation Of Annuity Death Benefits

Next Steps

The world of annuities is intricate, but understanding its landscape is crucial, especially when considering the future well-being of our loved ones. Whether dealing with qualified or non-qualified annuities, knowing the tax implications of death benefits empowers you to make informed decisions. Consult a financial advisor to understand your situation and the best steps forward. Your financial future, and that of your beneficiaries, is worth that time and diligence.

Annuity Taxation Upon Death

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Frequently Asked Questions

How do I avoid taxes on annuity death benefits?

Avoiding taxes on annuity death benefits often requires proper estate planning. Consulting a financial advisor or tax professional is essential. Options may include setting up trusts or selecting specific annuity beneficiary designations to mitigate potential tax implications. Always ensure compliance with laws.

Are death benefits from annuities subject to income tax?

Yes, death benefits from annuities are typically subject to income tax. Beneficiaries must pay taxes on any gains above the original investment. However, the original principal is usually returned tax-free. Always consult a tax professional for specific guidance.

How do spousal beneficiaries get taxed on annuity death benefits?

Spousal beneficiaries can often assume ownership of the annuity without immediate tax implications. However, any gains above the original investment are subject to income tax when they withdraw funds. Spouses have additional options, like continuing the annuity, which can impact taxation. Consulting a tax professional is advisable.

How do state taxes affect annuity death benefits?

State taxes on annuity death benefits vary by state. Some states tax the gains from annuities, while others don’t. Beneficiaries might be responsible for state inheritance or estate taxes, depending on where the deceased resided or where the beneficiary lives. Consulting local tax laws is essential.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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