About Annuity Death Benefits

Annuities can offer you a guaranteed income for life. But what happens after you die? If funds remain in your account, are they passed on to your heirs? Not necessarily. This is why some annuity owners consider adding death benefits to their annuities.

The thought of heirs receiving money from an annuity after your death can be comforting. But not all investors understand the benefits they pay for. Salespeople may not bring up the death benefits available in an annuity contract for any number of reasons. And annuities, as a whole, are fairly complex. There are so many different terms to know—deferred annuity, variable annuity, participation rates—and understanding how they can help meet your long-term financial goals can be a challenge.

What Are Death Benefits?

Death benefits are the money owed to heirs when the annuity owner or the annuitant passes away. The death benefit is usually paid out in one of two ways: as a lump-sum payment from an insurance policy, or as a percentage of the annuitant’s ongoing payments.

Types of Death Benefits

There are several different types of death benefit riders, but the two most common are basic death benefits and enhanced death benefits.

Basic death benefits. A basic death benefit rider offered by a variable annuity guarantees that after your death, the insurance company will pay your heirs at least the amount of the money you put into the annuity prior to it being annuitized. If the policy has been annuitized, there is no death benefit. The basic death benefit ultimately may not amount to much. If you wish for your heirs to receive more than what the basic death benefit offers, you could consider enhanced death benefits.

Enhanced death benefits. Enhanced death benefits come in the form of a “rider.” and offer step-ups—the insurance company steps up the value of your annuity on the anniversary date of when you took out the annuity. Enhanced death benefits come in a variety of forms, with the two most common being Highest Balance and Guaranteed Minimum Death Benefit (GMDB). The Highest Balance benefit results in the insurance company recording the account’s value each month. After your death, the highest monthly value recorded becomes the death benefit your heirs will receive. Variable annuity contracts often offer a GMDB rider. With this rider, the insurance company guarantees that your beneficiary’s payout on the annuity will be generally equal to the greater of the contract value at death or premium payments minus any withdrawals.

These benefits usually go into effect only if they would provide more than the annuity’s current value. So, if the annuity’s value is greater than the death benefit when the annuitant dies, then these benefits won’t be applicable. Also, if the annuitant has annuitized the policy—i.e., converted the policy into a series of periodic income payments prior to their death—then there is no death benefit. Most annuity contracts require an annuitant to annuitize the contract when they reach a certain age. But, remember, after annuitization there is no death benefit.

Additional Costs

Adding riders to your annuity contract comes with costs. In addition to the rider fee, there are base costs, step-up fees and other costs that could amount to a fraction of a percentage of your account value per year. This fee might seem small in isolation, but when added to the other fees of each additional rider on the annuity plus the costs of holding underlying investment products in the annuity (like mutual funds in the case of a variable annuity), it may eat into your account’s growth. So, while riders may sound comforting, it is always important to think carefully about the costs of any riders added to an annuity contract and be clear about the amount of all fees and additional costs. Calculating all the fees and costs of an annuity contract can help the investor assess whether the costs are worth the likely returns. Too often, investors don’t do their research and end up paying too much for too little return. This can have dire consequences on their retirement or legacy portfolios.

Tax Consequences

Any income your heirs receive from an annuity would be taxed as ordinary income. And tax rules around annuities can be complicated. For example, when the annuity death benefits are paid to the beneficiary as a lump sum, the beneficiary will have to pay taxes on the contract’s gains. This is because dividends, interest and capital gains credited to an annuity aren’t taxed until they are withdrawn. Taxes are deferred and reinvested to help accumulate assets for retirement.

For income tax purposes, an inherited annuity is considered income when the beneficiary receives it. If your beneficiary elects to receive periodic distributions, the portion of each payment that comes from accumulated earnings is taxable and the portion that comes from the original premium payment isn’t. If the beneficiary chooses to receive a lump sum, the tax is payable on everything above the original premium payment; the original premium payment amount is excluded from taxable income. To complicate matters even more, special rules exist for heirs who are entitled to receive guaranteed payments under an annuity contract. In this case, the tax rules are reversed so the beneficiary receives the money that represents the amount the annuitant paid for the policy, tax free, until it is used up. Then, subsequent amounts are taxed.

What Are Your Alternatives?

Fees and underlying costs can make annuity death benefits an inefficient way to leave money for your heirs, especially if you have a longer time horizon of 30 years or more. Other investment strategies such as a personalized investment portfolio may help provide you and your heirs with necessary growth and customization. Although investments in securities like stocks or bonds may not have a guarantee, they may reduce the fees you pay and allow you to invest for your specific investment goals and objectives.

If you are considering an annuity because of their guarantees but aren’t sure if it is the best option for you, our experienced Annuity Evaluation Specialists can help you properly assess these products.

Contact us to find out how we can help you.


i The contents of this article should not be construed as tax advice. Please contact your tax professional.