How an Annuity Death Benefit Works

An annuity death benefit is a financial feature that provides a payout to a designated beneficiary when the annuity holder passes away. Unlike traditional life insurance, an annuity’s death benefit often depends on the remaining contract value or a predetermined minimum amount. The payout structure can vary, with some beneficiaries receiving a lump sum while others opt for scheduled distributions. Depending on the type of annuity and any additional riders, the death benefit may grow over time or be influenced by market performance.

A financial advisor can answer your questions about retirement income, estate planning and more.

What Is an Annuity Death Benefit?

An annuity is a contract between you and an insurance company. You pay the insurer a set amount of money to purchase the contract, and in return, the insurer agrees to pay you according to a set schedule. Depending on the type of annuity these payments can begin right away if you have an immediate annuity or you can defer them until a later date.

As part of your annuity contract, a standard death benefit may be included. This ensures that a beneficiary receives a financial payout when you die. In that sense, it’s similar to a life insurance policy, although there are some key differences. Death benefits pay out differently in an annuity, and face different tax liabilities.

That annuity death benefit can help create a financial legacy. For example, you may want to leave money to your spouse to help fund their retirement. Also, you may name one of your children as a beneficiary and fund or increase their inheritance. Heirs can take an annuity death benefit as a lump sum payment or as regular payouts.

Determining the Size of an Annuity’s Death Benefit

Generally, there are two ways to determine a standard annuity death benefit. First, you can pay out any remaining assets to your beneficiary. Say you purchased a $500,000 annuity and it paid out $300,000 during your lifetime. The remaining $200,000 could pass on to someone else as part of the death benefit.

Secondly, you could choose a preset minimum amount for the death benefit. For example, the annuity can pay out exactly what you paid in for premiums, minus any amount you received. In that scenario, the amount paid to the beneficiary would depend on how much you paid for premiums. It would also factor in the difference between the annuity’s market value and the payments you’ve already received.

In either case, payouts could be unpredictable. But generally, the higher the value of the annuity and the value of the remainder once you pass away, the larger the death benefit.

Increasing an Annuity Death Benefit

Your insurance company may offer opportunities to increase your annuity death benefit. This typically involves adding riders to the annuity for a fee.

In terms of the different options that might be available, here are a few ways you could potentially increase the annuity death benefit:

Market-Linked Increases

Some annuity issuers will offer your beneficiary a higher death benefit depending on what’s happening with the stock market. For example, if you pass away during a market upswing, the annuity’s death benefit may automatically increase.

Annual Increases

Another option may be a death benefit that increases year over year as you get older. The idea behind this step-up is that the longer you live, the more money you’ll receive from the annuity. In exchange, the insurance company increases the death benefit payout available to your beneficiaries to offset this.

The advantage of these types of death benefit increases can be twofold. In the case of market-linked increases, you may be able to lock in market gains for your beneficiaries if the underlying assets in the annuity are performing well at the time of your death. At the very least, this type of benefit upgrade would guarantee the return of your premiums paid, less any investment gains.

With this type of increase or an annual step-up increase, you could leave behind a larger financial payout for your loved ones. Meanwhile, that could help when it’s time to pay taxes on your estate or cover burial and funeral expenses. However, those types of riders come at a cost. If you also have other assets to leave behind, such as life insurance, real estate, cash assets and investments, then paying more money to increase your annuity’s death benefit may not be necessary.

Annuity Death Benefit Riders

Aside from death benefit upgrades, there are other riders that can increase an annuity’s value. For example, you may be able to add a rider to cover long-term care in case you need nursing home care in retirement. Having this rider could reduce the amount of the death benefit. But it could provide funds to pay for long-term care if you don’t have a separate long-term care insurance policy. Remember that Medicare typically doesn’t cover long-term care.

When considering how to structure your annuity and its death benefit, look at the other financial tools you already have. A permanent life insurance policy, for example, could provide both a death benefit and cash value during your lifetime. It’s important to look at how the different parts of your financial plan work together. Make sure that you’re covering all the bases, but not paying more for those parts than you need to.

Tax Implications of Annuity Death Benefits

The tax treatment of an annuity death benefit depends on several factors, including whether the annuity was qualified or nonqualified, how the beneficiary receives the money and how much of the contract represents investment earnings. Understanding these rules can help beneficiaries estimate how much they may actually receive after taxes.

Qualified vs. Nonqualified Annuities

The first distinction is whether the annuity was purchased with pre-tax or after-tax money.

Qualified annuities, such as those held within an IRA or employer-sponsored retirement plan, are generally funded with pre-tax dollars. As a result, most or all of the distributions a beneficiary receives are typically taxable as ordinary income.

Nonqualified annuities are purchased with after-tax money. In these cases, the owner’s original investment, often referred to as the cost basis, is generally returned tax-free, while the investment earnings are taxed as ordinary income when distributed to the beneficiary.

No Step-Up in Basis

Unlike many appreciated investments held in taxable brokerage accounts, nonqualified annuities generally do not receive a step-up in basis when the owner dies. That means beneficiaries may still owe income tax on any deferred earnings that accumulated during the owner’s lifetime.

For example, assume someone purchases a nonqualified annuity for $300,000 and, at death, the contract is worth $425,000. A beneficiary who receives the proceeds would generally not owe income tax on the original $300,000 investment, but the $125,000 of earnings would generally be taxable as ordinary income.

How the Payout Option Can Affect Taxes

The way a beneficiary receives the death benefit may also affect when taxes are paid. Some beneficiaries choose a lump-sum distribution, while others may have the option to receive payments over time, depending on the terms of the contract and applicable tax rules.

Spreading distributions over multiple years may spread the taxable income across more than one tax year. Receiving the entire benefit at once could result in a larger amount of taxable income in a single year. Before selecting a payout option, beneficiaries should review the available choices and consider how each may affect their overall tax situation.

State Taxes May Also Apply

Federal income tax is only part of the equation. Depending on where the beneficiary lives, state income taxes may also apply to taxable annuity distributions. State rules vary, and some states provide different treatment for retirement income than others.

Because both federal and state taxes can affect the amount ultimately received, beneficiaries may benefit from reviewing the tax consequences before electing a distribution option.

Planning Ahead

The tax treatment of an annuity death benefit can influence how much of the contract ultimately passes to beneficiaries. Reviewing beneficiary designations, available payout options and the potential tax consequences before they become relevant can help avoid unexpected outcomes.

A financial advisor and tax professional can help evaluate how an annuity fits within your estate plan, estimate the potential tax consequences for your beneficiaries and compare annuities with other assets when planning to transfer wealth.

Bottom Line

A couple meeting with their financial advisor.

When adding an annuity to your financial plan, the death benefit is an important consideration. The annuity company you’re working with should be able to walk you through different death benefit scenarios to help you decide which one is the best fit for your needs.

Financial Planning Tips

Consider talking to a financial advisor about whether an annuity could be a good investment option for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
An annuity can be a valuable tool in your retirement income plan but it’s not the only way to create financial security for you and your loved ones. Drafting a will, checking your life insurance coverage and considering whether you need to establish trust are all things to keep in mind as you plan for the long-term.