Annuity Death Benefits

Annuities are popular for many of the attractive benefits they offer.  Most annuity owners purchased their annuity for the tax deferral of accumulated earnings.  Many annuities are purchased because of the safety features and income guarantees.  Interestingly, the one key feature that set’s annuities apart from other investments is not among the primary reasons annuity owners buy them, and that is the annuity death benefit.  In fact, many annuity owners aren’t even aware that there is a death benefit.  Yet, a lack of understanding about how the death benefit works could result in some unintended consequences for the beneficiaries.

Annuity death benefits are not often paid because most annuities are surrendered, transferred or annuitized for income prior to the death of the annuity owner or annuitant.  The death benefit is often an afterthought, yet it is one of the more important components of the annuity contract.  If neglected, it could be inadvertently structured in a way that can create some problems for the heirs.

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What the Annuity Owner Needs to Know about Death Benefits

The first thing that annuity owners must realize is that not all annuity death benefits are the same, and when structuring it, there are often several options that should be considered in light of a person’s financial and estate situation.  Unfortunately, the annuity death benefit is not often discussed by the annuity salesperson, either because it is not a subject they like to bring up, or they simply don’t understand the implications of the death benefit in a particular financial situation.  The end result is that the beneficiaries are often caught off guard when they learn of the tax or financial implications of the benefit payout.

Death benefits are included with most annuity contracts.  Depending on the type of contract, the death benefits vary in terms of how they are structured and how they are paid.  The annuity contract should provide details of both, however, it is important to have them explained thoroughly before purchasing the contract.

In many annuity contracts, there are options that can be selected as to how the death benefit is to be paid.  Some annuity owners may prefer that the beneficiaries not receive a lump sum payment, but, rather a series of periodic payments instead.  Some contracts offer enhanced death benefit features, but they are an added cost.  It is important to learn how these optional features work, how they will impact the beneficiaries, and whether they are worth the additional cost.

Annuity Death Benefit Considerations

In selecting a death benefit option there are two primary considerations: Taxation and legal issues.  If the annuity sales rep does not introduce these issues in the discussion, it is important to raise them by asking questions of the rep.  One of the primary advantages of annuities is that the benefits paid at death are not includable in the estate for probate purposes, yet this is many times not even discussed.

There are many other important considerations that should be discussed:

Tax Liability

When annuity death benefits are paid as a lump sum the beneficiary will be responsible for the taxes owed on the gains in the contract which could be a significant sum. 

Surrender Charges

If death occurs before the end of the surrender period, when charges are assessed for early surrender, the charges may be deducted from the death benefit proceeds.

Some annuity contracts waive the charges so it would be important to check the contract for this provision. Also, there may be an option for the beneficiary to take the proceeds in periodic payments which won’t result in surrender fees.   It is important that the beneficiaries understand the surrender provision of the contract.

Spouse as the Beneficiary

If the spouse is the primary beneficiary there may be an option to assume the annuity contract without a surrender fee.

Children as Beneficiaries

One option available to the children is to take the death benefit as annual payments that are paid for their life expectancy.  The benefit to doing this is that the tax burden is spread out over the lifetime payments.

Estate Considerations

When most assets are distributed to heirs, they receive a stepped-up basis meaning the heir new cost basis is the value of the asset at the time of death. Annuity death benefits are treated differently and the heirs will assume the original cost basis of the annuity, so the annuity gains will be includable in the estate for tax calculation purposes.

Variable Annuity Option

If the contract is a variable annuity there may be some additional options available that can protect the principal and, in some cases, the gains, against market losses.  This means that the beneficiaries will receive no less than the original principal and, depending on the option selected, they will also receive all or a part of the gains.

Annuitization Options

At the time of annuitization, when periodic payment are to begin, the owner may select from a number of options that can guarantee that the beneficiaries will receive either a lump sum refund or continued periodic payments.  These options are not automatic, so it is vital that they be carefully reviewed prior to annuitization.

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Annuities can be somewhat complex. As with any contract there are many provisions that need to be fully understood before entering into them.  The death benefit provision is sometimes slighted, either because the annuity sales rep doesn’t know how to introduce it into the discussion or because it is not a primary consideration of the annuity purchaser.  In either case, the important of annuity death benefits needs to be emphasized because at the time they are triggered, the consequences are beyond the deceased owner’s and the beneficiaries’ control.

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