How Death Benefits From Annuities Are Taxed

Death benefits from annuities are taxed differently depending on whether you or a beneficiary receives the money, and whether the annuity had started paying out

The tax treatment of an annuity death benefit depends on three things: who receives the money, whether the annuity was still in the accumulation phase (before payouts began) or the payout phase (after payouts began), and how much of the benefit is earnings versus your original contribution. The IRS taxes the earnings portion, but your original contribution comes out tax-free. If a beneficiary inherits the annuity, they may owe income tax on the earnings, but the timing and amount varies by situation.

The key difference is between return of principal (your money, not taxed) and earnings (the growth, which is taxed). An annuity death benefit usually includes both. Your beneficiary will receive a statement showing how much is which, and they will owe tax only on the earnings portion when they receive or withdraw the money.

Key Takeaways

• Death benefits paid before the annuity starts paying out are taxed only on the earnings portion; your original contribution returns tax-free to your beneficiary.
• If the annuity was already paying out when you died, your beneficiary may owe tax on the remaining balance, but the tax depends on the payout option you chose.
• Beneficiaries who inherit an annuity can often choose to take a lump sum or stretch the payments over time, and the tax bill changes based on that choice.
• The insurance company will issue a 1099-R form to your beneficiary showing the taxable portion, which they report on their own tax return.

Death benefits during the accumulation phase (before payouts begin)

If you die before the annuity starts sending you regular payments, the death benefit is usually the account value at the time of death. This includes your contributions plus any earnings. Your beneficiary receives the full amount, but only the earnings portion is taxable to them.

For example, if you put $100,000 into an annuity and it grew to $130,000 when you died, your beneficiary gets $130,000. They owe income tax on the $30,000 in earnings, but the $100,000 is not taxed because it was your money going in. The tax rate depends on your beneficiary's tax bracket in the year they receive the money.

Some annuities include a may provide minimum death benefit, which means if the account value dropped below what you paid in, your beneficiary still gets at least your original contribution. In that case, there is no earnings to tax, and the entire payment is tax-free.

Death benefits after the annuity starts paying out

Once you start receiving regular payments from the annuity, the tax treatment of a death benefit depends on which payout option you chose. The most common options are a life annuity (payments stop when you die), a period-certain annuity (payments continue to a beneficiary for a set number of years), or a joint-and-survivor annuity (payments continue to a spouse or other beneficiary for life).

If you chose a life annuity with no survivor benefit, there is usually no death benefit to your beneficiary—the payments straightforward stop. If you chose a period-certain or joint-and-survivor option, your beneficiary receives the remaining payments. Those payments are taxed the same way your payments were taxed: part is a return of your contribution (not taxed) and part is earnings (taxed as ordinary income).

The insurance company calculates what portion of each remaining payment is taxable based on your life expectancy at the time you started receiving payments. Your beneficiary will receive a 1099-R form showing how much of each payment is taxable.

How beneficiaries report the tax on their return

Your beneficiary will receive a Form 1099-R from the insurance company. This form shows the total amount received and how much is taxable. Your beneficiary reports the taxable portion on their own tax return as ordinary income, not as capital gains.

If your beneficiary receives the death benefit as a lump sum, they report all the taxable earnings in the year they receive the money. If they choose to take the money in installments or stretch the payments over time, they report only the taxable portion of each payment in the year they receive it. This can spread the tax bill across multiple years, which may result in a lower overall tax rate.

Inherited annuities and the stretch option

When a non-spouse beneficiary inherits an annuity, they have choices about how to take the money. They can take a lump sum, take payments over a set period, or in some cases stretch the payments over their own life expectancy. The choice affects when and how much tax they owe.

A lump sum means all the taxable earnings are reported in one year, which could push your beneficiary into a higher tax bracket. Stretching the payments over time spreads the tax across multiple years. However, tax rules changed in 2020, and most non-spouse beneficiaries must now withdraw the entire inherited annuity within ten years, though they can choose how to spread those withdrawals within that window.

A spouse who inherits an annuity has more flexibility. They can treat the annuity as their own, continue receiving payments as originally set up, or roll it into their own IRA. Each option has different tax consequences, and a spouse should review the options with a tax professional.

State taxes and the death benefit

In addition to federal income tax, your beneficiary may owe state income tax on the taxable portion of the death benefit. State tax treatment varies—some states do not tax annuity income, while others tax it the same way the federal government does. Your beneficiary should check their state's rules or consult a tax professional to understand their full tax bill.

A few states have no income tax at all, which can make a difference if your beneficiary lives in a different state than you did. The insurance company will not withhold state tax automatically, so your beneficiary may need to plan for this when they file their return.

What happens if the annuity lost money

If the annuity account value dropped below what you paid in, the death benefit may be less than your contribution. In that case, your beneficiary receives a smaller amount, and there is no earnings portion to tax. The entire death benefit is a return of your money and is not taxable.

This situation is rare with fixed annuities, which may provide a minimum return, but it can happen with variable annuities if the underlying investments performed poorly. Some variable annuities include a may provide minimum death benefit that protects against this, ensuring your beneficiary receives at least your original contribution even if the account value is lower.

Frequently Asked Questions

Do I have to pay tax on an annuity death benefit right away?

No. Your beneficiary pays tax when they receive the money, not when you die. If they take a lump sum, they report the taxable portion on their tax return for that year. If they take payments over time, they report only the taxable portion of each payment in the year they receive it.

Is the entire death benefit taxable?

No. Only the earnings portion is taxable. Your original contribution comes out tax-free. The insurance company will show on the 1099-R form how much of the death benefit is earnings and how much is your contribution.

What if my beneficiary is in a low tax bracket?

Spreading the death benefit over multiple years through installment payments may keep your beneficiary in a lower tax bracket each year, resulting in less total tax owed. A lump sum could push them into a higher bracket for one year. Your beneficiary can choose the withdrawal method that works best for their situation.

Can a spouse avoid taxes on an inherited annuity?

A spouse can roll an inherited annuity into their own IRA, which delays taxes until they start taking withdrawals. They can also treat the annuity as their own and continue receiving payments. These options are not available to non-spouse beneficiaries, who must withdraw the entire annuity within ten years.

Will the insurance company withhold taxes from the death benefit?

The insurance company will withhold federal income tax from the taxable portion of the death benefit unless your beneficiary tells them not to. Your beneficiary can request no withholding, but they will then owe the tax when they file their return. Withholding is usually 10 percent, but your beneficiary can request a different amount.