Are Annuity Death Benefits Taxable? Understand the Rules

Are your retirement nest eggs secure? Have you considered what happens to your hard-earned savings after you’re gone? One question often looms large for retirees and those planning for retirement: are annuity death benefits taxable?

The short answer is: it depends. Annuity death benefits are taxed as ordinary income, but the specific tax treatment depends on whether the annuity was qualified (funded with pre-tax dollars) or non-qualified (funded with after-tax dollars). For qualified annuities, the entire amount is taxable. For non-qualified annuities, only the earnings portion is taxable.

What Is an Annuity Death Benefit?

An annuity is a financial product that provides a steady income stream, usually during retirement. A death benefit is the money your chosen beneficiary receives when you pass away. This can be your spouse, children, other family members, or a friend.

Different Tax Rules for Different Beneficiaries

Spouse as Beneficiary

If your spouse inherits your annuity, they have more flexibility and generally face fewer immediate tax implications. A spouse can continue the annuity in their name, deferring taxes until they take withdrawals, or they can opt for a lump sum. The death benefit is typically not subject to estate tax due to the unlimited marital deduction, but this depends on proper estate planning.

Non-Spouse as Beneficiary

Non-spouse beneficiaries (children, other family, friends) will owe income tax on the death benefit they receive. They can choose to receive the death benefit as a lump sum or as periodic payments. The lump sum is subject to higher immediate taxation, whereas periodic payments spread out the tax burden.

What Are the Different Types of Annuities?

There are several types of annuities, each with different features and benefits. 

• Fixed Annuities: Offer a predictable income.
• Variable Annuities: Potential for higher returns but also carry more risk.
• Indexed Annuities: A middle ground, with a minimum guaranteed income and potential market-linked growth.

How Are Annuities Taxed?

Annuities do offer tax-deferred growth. Taxes are paid on withdrawals, and the tax treatment differs based on whether the annuity is qualified or non-qualified.

Factors That Influence Tax Treatment

Type of Annuity

Qualified annuities are funded with pre-tax dollars, so the entire death benefit is taxable as ordinary income. Non-qualified annuities are funded with after-tax dollars, so only the earnings portion is taxable

Certain riders, like guaranteed minimum death benefits, can also affect the taxable amount.

Your Estate’s Size

The federal estate tax exemption is $12.92 million per individual (as of 2023), and amounts exceeding this may be subject to estate tax. State estate or inheritance taxes vary. Annuity death benefits can be included in your taxable estate.

Some states also have their own estate or inheritance taxes with varying thresholds.

State Tax Laws

Some states tax annuity death benefits as income, while others don’t. The tax rates and rules can vary. As mentioned above, these can add another layer of tax implications depending on your state of residence.

Federal Estate Tax Exemptions

If your spouse is the beneficiary, they may be able to “port” your unused estate tax exemption, potentially shielding more of the death benefit from taxes. Portability allows a surviving spouse to use the unused portion of the deceased spouse’s estate tax exemption.

 You can gift a portion of your annuity each year (up to the annual exclusion limit) to your beneficiaries to reduce the size of your taxable estate.

Strategies to Consider for Reducing the Tax Bite

While annuity death benefits can be a valuable asset, you still need to plan for potential taxes. Several strategies can help lessen the tax burden on your loved ones.

Use Life Insurance to Offset Taxes

Consider purchasing a life insurance policy. Proceeds from a life insurance policy are generally not subject to income tax, and you can use it to cover the taxes owed on the annuity death benefit. This way, your beneficiaries receive the full value of your annuity.

Give to Charity

If you’re charitably inclined, you could designate a portion of your annuity death benefit to a charity. Designating annuity benefits to a charity can reduce taxable estate size.

Explore Trusts

Trusts can be a helpful tool for managing taxes on annuity death benefits in certain situations. They provide greater control over how and when you distribute your assets, potentially offering tax advantages.  Trusts can provide tax advantages and greater control over asset distribution, but are complex and should be set up with professional advice.

How to Make the Right Annuity Choice for Your Retirement

Choosing the right annuity is a big decision that involves considering several factors. While taxes are important, you should consider financial goals, risk tolerance, and individual circumstances as well.

Start with Your Financial Goals

First, think about your financial goals. Are you mainly looking for guaranteed income during retirement, or do you want your investment to grow? Your answer will guide you towards different types of annuities. If stability is important to you, a fixed annuity might be a good fit.

If you are comfortable with some risk and want the chance for higher returns, a variable or indexed annuity could be better.

Assess Your Risk Tolerance

Next, consider your risk tolerance. Like any investment, annuities come with varying levels of risk. Fixed annuities offer the lowest risk, while variable annuities carry the highest. Be honest with yourself about how much risk you’re comfortable taking before making a decision.

Read the Fine Print

Review the terms and conditions of each annuity contract. Pay attention to fees, surrender charges, and any other details that could affect your investment.

Get Expert Advice

The best way to decide about an annuity is to consult a financial professional. They can assess your needs and recommend an annuity that fits your overall financial plan. Detailed review of annuity contracts, fees, and conditions is crucial, and consulting a financial professional is recommended for tailored advice.

Don’t Leave Your Loved Ones Guessing, Get Annuity Advice Today

So, are annuity death benefits taxable? It’s not a simple yes or no answer. While the death benefit itself isn’t taxed, the way you distribute it and who receives it greatly affects the tax implications. Spouses often have more flexibility and tax benefits than non-spouses.

Remember, each annuity contract is different, and many factors can influence how the IRS taxes death benefits.

Don’t deal with annuity death benefits alone. Connect with a SafeMoney.com financial professional today and get the personalized guidance you need. Visit our Find a Financial Professional page to request a no-obligation appointment or call us at 877.476.9723 for a personal referral.