What Is the Income Tax Treatment of the Death Benefit of a Non-Qualified Annuity?
Original post by Leslie McClintock of Demand Media
Many investors purchase annuities because of the guarantees that are available with the annuity contract. Unlike mutual funds, annuity issuers frequently guarantee a minimum death benefit to heirs in the event of the death of the annuitant or original contract owner, or a guaranteed minimum income in retirement. Those inheriting annuities should understand how annuities not held in retirement accounts are treated under the tax system, so they can do appropriate planning.
General Rule for Early Distributions
The general rule for annuity distributions prior to the age of 59-1/2 is that the IRS assesses a 10-percent penalty on the distribution, along with income tax on the withdrawal. However, those who receive an annuity distribution as a result of the death of the annuity owner -- provided the annuity owner and the annuitant are the same entity -- are exempt from the 10-percent penalty.
Termination of the Contract
Death of an owner results in the termination of an annuity contract. If multiple people own the same annuity, the death of any one of them terminates the contract for all. If the contract terminates due to a death after the date on which the annuity is converted to a stream of income, beneficiaries must continue taking income from the contract at the same pace as the original annuitant took income, or faster. If the contract has not yet been annuitized, beneficiaries have up to five years to take the distribution, in full. The annuity proceeds are taxed as ordinary income.
As an alternative to taking the money out of an annuity within five years of the annuitant's death, you can also elect to take a level stream of income over the remainder of your expected life span, or the joint life span of yourself and a beneficiary, such as a spouse. This rule provides an exception to the five-year rule; you can take longer than five years to empty an inherited annuity if you do so under this rule.
Rules for Spouses
If a spouse inherits an annuity, the surviving spouse may elect to treat the annuity as her own, rather than as an inherited annuity. This rule allows her to continue to defer annuities that have not been annuitized yet, maximizing the benefits of tax deferral within the annuity contract.
Tax Basis and Exclusion Ratios
When you take money out of a nonqualified annuity -- whether inherited or not -- the gains in the annuity that are paid out to you are taxed as income. However, you will receive the portion of the income attributable to the original owner's contributions returned to you tax-free over your remaining life expectancy. To find the percentage of income exempt from income taxes, take the total amount invested in the annuity with nondeductible contributions -- the tax basis of the annuity -- and divide this figure by the total expected payout of the annuity contract. The result is the exclusion ratio.
- MetLife.com: Taxation of Non-Qualified Annuity Contracts
- National Underwriting: How To Explain the Exclusion Ratio
About the Author
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.