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 individual. 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.
- When you buy a tax-deferred annuity, you will be asked to name three parties: the beneficiary, the owner, and the annuitant.
- The annuitant and owner of the annuity are often the same person on the contract.
- When you name a beneficiary, they are entitled to the annuity funds when the annuity contract owner dies.
Beneficiaries of non-qualified (not held in an IRA or another 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. They will thus 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.
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 their death.
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.
Unusual Owner-Annuitant Designations
Annuity Jointly Owned by Husband and Wife
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.
However, if either of you dies before annuitizing the contract, there could be problems because the Internal Revenue Service (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.
Annuities are complex financial products, so it may be useful to consult an annuity specialist before purchasing one.
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 an individual is the annuity's owner, ther child is the annuitant, and their spouse is the primary beneficiary. If the child dies, the owner's spouse (i.e., the parent of the annuitant) has to take the proceeds and pay the income tax just as any other non-spousal beneficiary would.
On the other hand, if the owner dies first, the spouse can step in and continue the annuity's tax deferral. If remarried later, they could name the new spouse as beneficiary. Upon death, the new spouse would be able to continue the tax deferral.
Non-Spouse Named as Beneficiary (by Non-Annuitant Owner)
To modify the above example, suppose that the original owner names a sibling instead as the beneficiary and keeps the child on as the annuitant. In this case, when the owner dies, the sibling must remove the funds just as any other non-spousal beneficiary is required to do.
What You Should Do
As an Owner
Investors should keep good records of the amounts put into annuities. Also, you'll want to check to see who is named as the owner, annuitant, and beneficiary.
Meanwhile, 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.
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 the federal estate tax was paid, you could 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.