Annuity Beneficiary

Annuities are insurance products that provide a contractually guaranteed stream of income, either immediately or in the future. The main benefits include tax-deferred growth, guaranteed payments over a lifetime or a specified period and potential death benefits.

Although not all types of annuities offer a death benefit, it is crucial to name beneficiaries on the contract. If there are contractually guaranteed benefits remaining after the owner’s death, a named beneficiary will inherit them as a lump sum or through a series of payments. Without a named beneficiary, the assets will go through probate, a court-managed distribution process that can be lengthy and challenging. Naming beneficiaries can save your heirs significant time and effort by avoiding probate.

Beneficiaries are individuals or entities designated to inherit remaining assets after someone’s death. The death benefit for an annuity beneficiary depends on the contract type, policy riders and annuitization status.

Beneficiaries are classified into two categories: Primary and Contingent.

Maintaining up-to-date beneficiaries is one of the simplest yet most significant estate planning decisions. Without designated beneficiaries, your assets will go through probate, where the court decides their division. If your beneficiaries don’t align with your current wishes, you risk passing assets to unintended individuals.

Only the annuity owner has the authority to name beneficiaries. If the owner and the annuitant (the person on whose life the contract is based) are different, the annuitant cannot make these changes.

The owner can designate beneficiaries when setting up the annuity and can update this information anytime. Most insurance companies require changes to be made online or via paper forms. In some cases, there may be restrictions, such as a divorce court order mandating a former spouse as a beneficiary.

Beneficiaries are listed by name, date of birth and percentage of assets assigned. Optional details like Social Security number or address may also be included. If multiple beneficiaries are named, their combined shares must total 100% in their respective categories—primary and contingent.

For entities such as trusts or charities, the name, establishment date and tax identification number are required. Naming an entity as a beneficiary can involve complex tax and inheritance issues, so consulting with an estate attorney or qualified financial advisor is advisable.

To understand the beneficiary’s role in an annuity contract, it’s important to know that each contract lists three parties: the owner, the annuitant and the beneficiary. Although the owner and the annuitant are typically the same person, this isn’t always the case and can introduce complexity into some contracts.

Annuitization is the process of turning a lump sum of money into a guaranteed series of payments, usually for life. Doing this can have profound implications for the inheritance of the annuity beneficiaries.

For example, consider a $100,000 deferred income annuity. Bill is both the owner and the annuitant, while his daughter Sarah is the sole beneficiary. Bill plans to annuitize this contract in five years with a life-only option.

If Bill passes away before the contract is annuitized, Sarah will inherit the contract and its full balance. She has several options for accessing the death benefit. She can choose a lump-sum payment, receiving the entire balance in one payout and handling any tax implications herself.

Alternatively, Sarah can opt for periodic payments. The Single-Life Payout option distributes the balance over her lifetime, with any remaining value surrendered to the insurance company upon her death. The Term-Certain Payout spreads the payments over a predetermined period, such as 10 or 20 years.

Additionally, if the beneficiary is an entity like a trust, charity or estate, the 5-Year Rule requires that the entire balance be withdrawn within five years of Bill’s death.

If Bill annuitizes the contract, he will receive payments until his death. Upon his death, the contract will end, and Sarah will receive nothing. A life-only annuity has no additional guarantees or protections that extend payments beyond the life of the annuitant (Bill), regardless of how long he lives.

Using our example above, let’s adjust Bill’s choices. Instead of a life-only payout, if Bill adds additional guaranteed riders such as a Period Certain or Cash Refund, Sarah might be able to inherit some death benefit.

Here are two examples:

Bill has annuitized his contract with a Life and 10-Year Period Certain payout. This means the contract will pay him for his entire life, but it guarantees a minimum of 10 years of payments. The monthly payment on this contract is less than that of a Life-Only annuity, but it offers additional guarantees.

If Bill lives beyond the 10-year period, Sarah will not inherit anything. However, if Bill passes away within the first five years, Sarah will inherit the remaining payments for the balance of the 10-year period.

Bill has annuitized his contract with a Life with Cash Refund payout. This means the contract will pay him for his entire life and guarantees that the total amount paid into the annuity will be returned to him or his beneficiary. The monthly payment on this contract is less than that of a Life-Only annuity, but it offers additional guarantees.

If Bill lives long enough to receive payments equal to the total amount paid into the annuity, Sarah will inherit nothing. However, if there is any remaining balance at the time of Bill’s death, Sarah will inherit that amount as a lump sum or a series of payments, depending on the payout options available.

Variable annuity contracts allow investors to allocate their contributions directly into the stock or bond markets, rather than depending on the fixed returns of a fixed annuity or fixed index annuity. While these contracts offer the highest growth potential, they also carry increased risk due to market fluctuations.

To help manage these risks, many variable annuities include additional protection through riders. One such rider is the guaranteed minimum death benefit (GMDB) Rider, which guarantees that if the annuity owner dies during the accumulation phase, before annuitization, the beneficiary will receive a minimum guaranteed amount.

Regardless of how an annuity was funded—whether from qualified retirement funds or after-tax contributions—annuities do not receive a step-up in tax basis at the time of the owner’s death. The first line of defense against taxes is proper estate planning conducted by the owner before inheritance occurs.

Beneficiaries who inherit an annuity should be prepared for taxable income in almost all cases. Choosing the right payout option at the time of inheritance can make a significant difference by spreading out payments over multiple years and minimizing a large, single tax event.

Depending on how income is withdrawn, one of two situations will occur. If the contract is annuitized, each payment will be taxable proportionately to the amount of tax basis and growth within the contract at the time it was annuitized. For example, if a contract worth $100,000 was originally funded with $50,000 of contributions, all payments will be 50% taxable and 50% tax-free.

If the contract is not annuitized, withdrawals are handled on a Last In, First Out (LIFO) basis. This means that all growth in the contract will be withdrawn first. Using the example above, the first $50,000 of withdrawals (plus any additional growth) will be 100% taxable as income, and the $50,000 of tax basis will be entirely tax-free.

Immediate annuity contracts funded with non-qualified money have an exception to the 10% early withdrawal penalties usually applicable to the taxable portion of withdrawals. As long as the contract is paying substantially equal payments at least annually and the payments begin within one year of purchase, the owner is exempt from the penalty.

Note: Early withdrawal penalties generally apply to any taxable annuity income, affecting both qualified and non-qualified contracts, which must meet the age 59½ threshold to avoid a 10% penalty. However, there are exceptions to this rule, including specific situations or contracts. In addition to the exceptions mentioned above, there are also exceptions for contracts established before 1982 and/or 1986, certain federal employee plans, personal injury settlements and others. These exceptions are beyond the scope of this article, so we suggest consulting a qualified tax advisor for guidance.

Estate planning is both complicated and personal. Working with a local estate planning attorney will give you the best opportunity to shape your legacy into an efficient and organized plan.

Annuities are designed to produce income during your lifetime and may not always be the most effective way to pass on assets to heirs due to the taxable income they generate. While annuities excel at providing sustainable income, which can reduce the need to draw from other assets like Roth IRAs or taxable brokerage accounts, there are often better strategies for wealthy individuals. For instance, annuities can be used to fund a level-premium life insurance policy, converting annuity income into tax-free life insurance proceeds for heirs.

Before incorporating annuities or any other strategy into your estate plan, it is important to understand the tax implications of any changes. Working closely with both a tax advisor and an estate planner is the best way to ensure your estate plan is as robust as possible through this complicated process.