What Are the Tax Consequences to the Beneficiary of My Annuity

Retirees especially like annuities because annuities can assure them an income for life. But some retirees will die before beginning their annuity or receiving all their guaranteed annuity benefits. Their beneficiaries will then receive those benefits. This article explains how those beneficiaries are taxed on those benefits.

Retirees often hold their annuities as deferred annuities as a back-up for those later retirement years when they'll begin annuity payments only when other retirement income falters or when savings become depleted. But if they die before beginning their annuity, the designated annuity beneficiary will have to pay tax on all or a portion of those benefits. The same is true for annuities that have begun their payouts but those payments are guaranteed for some term of years beyond which the annuitant's owner died.

Annuities that are created within a government regulated qualified plan are called qualified annuities. All the owner's contributions to them are deductible, so all the annuities earnings and contributions will be taxed as ordinary income no matter who receives those annuity payouts.

But most annuities are nonqualified. In this case the contributions owners made to them are not deductible (i.e. they are after tax contributions). These contributions will never be taxed by anyone; they constitute the 'tax basis' of their annuity investment contract.

But all nonqualified annuity earnings are tax-deferred. This helps the annuity investment to annually compound faster because part of those earnings is not taxed away each year so it can participate in future growth. However those tax-deferred earnings will eventually be taxed upon withdrawal - by either the owner or his beneficiary.

*Annuitant's (owner's) taxation:

If a partial withdrawal is made, the IRS demands that all earnings come out first before the any untaxed contribution (i.e. the basis) comes out. So these withdrawals - as long as there are earnings within the annuity - are completely taxable as income.

But under regular monthly payments - as when the annuity is 'annuitized' - a portion of each payment is not taxed but treated as a return of your contributions (i.e. your tax basis) while the remaining part is treated as earnings - and taxed as income. This is one of the tax benefits of annuitization payments. An exclusion ratio is the ratio of the monthly annuity payout that's not taxed. It's calculated for you by the insurance company.

Under a life annuity, it's possible that an annuity owner will live beyond his life expectancy and receive enough payments to have recovered all his contributions (i.e. his tax basis). When that occurs, all of each subsequent payment is fully taxed as earnings - i.e. there's no longer an exclusion ratio.

*Beneficiary's taxation:

After-tax contributions made by the deceased owner will remain untaxed when received by the beneficiary as I mentioned above. And of course, all those tax-deferred earnings within the annuity will be taxed as ordinary income to the beneficiary.

Usually, if the annuitant had begun receiving lifetime payments, no benefits would be left for a beneficiary. But if the contract called for a fixed term guaranteed payments, the beneficiary would received those remaining payments of that fixed term taxed at the deceased's exclusion ratio.

If the annuity owner died before beginning annuitization of his annuity - so the annuity was still a 'deferred annuity'- provision may be made to give the beneficiary either a lump sum distribution of the deferred annuity or a series of payments. For the lump sum payment, the beneficiary would only pay tax on the earnings portion.

But if he takes a series of guaranteed payments instead of a lumpsum, the beneficiary would not be required to pay taxes on any of the payments until the deceased owner's contribution were fully received. So the annuity's basis would presume to be withdrawn first. Any payments beyond that would be fully taxed as ordinary income.

A beneficiary who earns a substantial income already can lose a lot of that taxable portion of the annuity as he's it pushes him into a higher tax bracket. That's why a lump sum distribution may be especially bad for him.

Shane Flait helps you with your financial legal, tax, and retirement goals.
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