Annuitization – Life With Period Certain
In this case, payments continue for the lifetime of the contract holder (or the contract holder and their spouse if a joint-life annuity), with a guaranteed minimum period for the payments to last. Period-certain durations of 10 or 20 years are common. If the annuitant dies prior to the end of the period, their beneficiaries receive payments for the remainder of the period. For example, with a life and 20-year period-certain annuity, if the annuitant dies in year 15, then the beneficiaries would receive the remaining five years’ worth of payments.
Annuitization – With Period Certain Only
With this type of annuitization, income is paid for a set period of years. If the contract holder dies before the end of the duration of the period certain, their beneficiaries receive payments for the rest of the designated time period.
Annuitization – Life With Refund
Under this annuitization scenario, payments are made for the life of the annuitant. The insurer guarantees that the payments to either the annuitant or their beneficiaries will be equal to at least the amount of the premiums that the contract owner paid into the contract. If the annuitant dies before this occurs, the remainder of the payments will be made to the contract beneficiaries.
Annuity Death Benefit Riders
Depending upon the insurer and the type of annuity, annuity contract owners may have an option to add an enhanced death benefit rider to the contract. The payment terms of these riders will vary but they can be a way to ensure your client’s beneficiaries receive a payout from the contract when your client dies. As with most contract riders, there is a cost to a death benefit rider that can reduce the contract owner’s living benefits.
Qualified vs. Nonqualified Annuities
With a qualified annuity that is held inside of an IRA or other type of retirement plan, the death benefit will be governed by the beneficiary designations on the plan. The annuity is considered an asset of the IRA, 401(k) or other type of qualified plan and the distribution rules upon death for that type of retirement plan governs.
If the spouse is the beneficiary, he or she will have several options including taking the money within five years or treating the IRA as their own. Most non-spousal beneficiaries are required to take the funds within 10 years under the Secure Act rules for inherited IRAs.
For nonqualified annuities purchased with after-tax money, the beneficiary or death benefit rules of the annuity contract govern. There may be an option for spousal continuance in some cases. Some beneficiaries may be required to withdraw the proceeds of the annuity within five years. As discussed above, a lump-sum distribution is a common option, especially if the contract had not been annuitized prior to the owner’s death.
Are Annuity Death Benefits Taxable?
In the case of a qualified annuity, the tax rules for distribution to the account beneficiaries will govern. If the annuity was held in a Roth IRA, the distribution to non-spousal heirs may not be taxed if the owner had met the requirements of the five-year rule prior to their death.
If the contract was held in a traditional IRA or other traditional retirement account, then the death benefit proceeds will generally be taxed. This includes both the earnings in the contract plus the amount of the contract’s premium. In most cases, a spousal beneficiary will have the option to treat the account as their own, avoiding immediate taxation.
In the case of a nonqualified annuity, the earnings portion of the annuity is taxed upon withdrawal. The premiums paid into the annuity by the original contract owner are generally not taxable. If the beneficiary, including a spouse, takes the benefit as a series of payments over time then the exclusion ratio applies. This means that a portion of each payment is taxable, the portion applying to the premiums is not.
Annuity Death Benefits and Estate Planning
Annuities can be complicated when looking at them as a retirement planning vehicle. When you add in the death benefit and how that might play into your client’s estate planning desires as far as leaving a legacy for their heirs, they become even more complex. While a number of death benefit issues and options were discussed above, this is not a complete list in that there is a wide range of contracts, and some may have death benefit options that differ a bit form what was outlined above.
For a pure death benefit, life insurance may be the better choice. But annuities offer the benefit of guaranteed income for life and the death benefits can be lucrative in some cases. Your clients need your help in combining the retirement benefits of an annuity with advice for optimizing the contract’s death benefits for their heirs.
