When you purchase a tax-deferred annuity, you have to name three parties: The owner, the annuitant and the beneficiary. The owner makes the initial investment, decides when to begin taking income and can change the beneficiary designation at will. The annuitant's life is the measure that is used to determine the benefits to be paid out under the contract. The named beneficiary is entitled to the annuity funds when the annuity contract owner dies. Generally, the owner and the annuitant are the same person - when they are not the same person, things can get complicated when one of them dies and beneficiaries can be hit with a big income tax bill if they don't understand the rules. In this article, we'll go over some of the situations that can occur when an annuity owner or annuitant dies and provide some steps that each party can take to protect their assets and reduce tax liability.
TUTORIAL: Retirement Plans
Beneficiaries of non-qualified (not held in an IRA or other retirement plan) annuities cannot take advantage of the step-up in basis provision in the tax code as they might with other assets you leave them. Therefore, they will owe ordinary income taxes on all gains in the account. However, if they annuitize the contract, a portion of each annuity payment will be considered a tax-free return of principal. This is determined by calculating the exclusion ratio and could spread the tax liability out over a longer time. (To read more basics to inheritances, see Refusing An Inheritance and Life Insurance Distribution And Benefits.)
A surviving spouse beneficiary of an annuity is treated as the new owner. This will allow your spouse to take your place and continue to defer the income taxes until he or she dies.
Unlike spousal beneficiaries, non-spouse beneficiaries of non-qualified annuities can't simply assume ownership; as beneficiaries, they must take the benefits within five years. However, they can annuitize the contract within 60 days of your death instead of receiving a lump sum. The payments must begin no later than one year after you die.
(For more information on beneficiaries, see Update Your Beneficiaries, The Importance Of Sept 30 For Multiple Beneficiaries, Problematic Beneficiary Designations - Part 1 and Part 2.)
Unusual Owner-Annuitant Designations
A Husband and Wife Jointly Own an Annuity:
You and your spouse might jointly own the annuity contract. This may have been done for Medicaid planning purposes. For example, if either of you enters a nursing home, the other could annuitize the contract based on the stay-at-home spouse's life expectancy. This would make the asset exempt for determining whether you qualify for Medicaid. (For related reading, check out Medicaid Versus LTC Insurance.)
However, if either of you dies before annuitizing the contract, there could be problems because the IRS requires that beneficiaries take the proceeds as stated in the previous section upon the first joint owner's death. Consequently, the beneficiaries would have taxes to pay, while the surviving joint owner would lose the funds.
The Owner, Annuitant and Beneficiary Are Different People
There have been advisors who have suggested that annuity owners name a younger person as the annuitant. This would stretch out the payments and associated income tax liability for a longer time. However, if the annuitant dies before the owner, the beneficiaries must remove the funds.
As a hypothetical example, suppose that a husband is the annuity's owner, his son is the annuitant and his wife is the beneficiary. If the son dies, the owner's wife (the mother) has to take the proceeds and pay the income tax just as any other non-spousal beneficiary would.
On the other hand, if the husband dies first, the wife can step into his shoes and continue the annuity's tax deferral. If she remarries, she could name her new spouse as beneficiary. At her death, her new husband could step into her shoes and continue the tax deferral.
The Non-Annuitant Owner Names a Non-Spouse as Beneficiary:
To modify the above example, suppose that the husband names his sister as the beneficiary and keeps his son as the annuitant. In this case, when the husband dies, his sister must remove the funds just as any other non-spousal beneficiary is required to do.(For more on this, see Selecting The Payout On Your Annuity.)
What You Should Do
As an Owner:
Investors should keep good records of the amounts put into annuities. Also check to see who is named as the owner, annuitant and beneficiary.
Review your annuities to interpret beneficiary distribution provisions. You may find that there are surrender charges at the death of a non-annuitant owner but not at the annuitant's death. Or there might be a waiver on surrender charges when an annuitant, but not the owner, enters a nursing home. (For further reading, see Taking The Bite Out Of Annuity Losses.)
As a Beneficiary:
If you have inherited an annuity, ask the annuity company to calculate the payments you could receive under several different systematic payout options, such as lifetime, 20-year and 10-year options. Have them provide the exclusion ratios so you can determine the after-tax consequences. Then compare this to receiving a lump sum.
Also, don't forget that if federal estate tax was paid, you can claim an income tax deduction for the amount of the estate tax attributable to the annuity as part of your itemized deductions on Schedule A.
The Bottom Line
For owners, annuitants and beneficiaries alike, knowing your options and staying informed is the best way to avoid unpleasant financial surprises and unnecessary costs.