What Happens to an Annuity When You Die?

One of the benefits of an annuity is the option to receive a lifetime income stream, even if you live a long time. However, you can also tailor these insurance contracts to help take care of a loved one you've chosen as your annuity beneficiary in the event of your passing.

Before making a purchase, it's important that you understand how annuities work and how different types of contracts will affect the annuity death benefit.

The Annuity Accumulation Phase vs. Payout Phase

Because they can be highly customizable, figuring out what happens to an annuity when you die depends a lot on the type you purchase. In the case of a deferred annuity, where payments don't begin right after the purchase, the timing of death is also an important factor.

Accumulation Phase

The accumulation phase is when the annuitant is still putting money into their account. Should the annuitant die during this time, the beneficiary will typically receive an annuity death benefit that's equal to the current value of the contract or the total amount of premiums the annuitant has paid — whichever is greater.

Payout Phase

Things work a bit differently if the annuitant dies when the deferred annuity is already in the payout phase. With a single-life or immediate annuity, the payments will simply cease at that point. However, you can purchase contracts that will provide payments to one or more beneficiaries after the annuitant's passing.

These options include:

• Life With Period Certain: When the annuitant dies, the beneficiary receives payments for a fixed number of years.
• Joint & Survivor: The contract designates multiple annuitants — often spouses — and payments continue until the last surviving person dies. With some contracts, payments are reduced upon the death of the first annuitant.
• Amount Certain: The contract specifies a fixed amount that will be paid to the beneficiaries after the annuitant dies. The length of the payout depends on the initial amount of the annuity and the size of each payment.

It's also worth noting that some annuities contain a provision known as "spousal continuation." In this case, if the beneficiary is the annuitant's spouse, the individual assumes all the rights of the original annuitant. He or she chooses when to withdraw funds from the annuity and has the ability to select new beneficiaries.

Payout Options for a Beneficiary

The owner of an annuity can typically choose one or more individuals or charities as beneficiaries for the policy upon the annuitant's death. Among the more common possibilities are:

• Lump Sum Distribution: The beneficiary receives the amount of the distribution in a single payout.
• Nonqualified Stretch Provision: Sometimes called the "life expectancy method," this option provides regular payments for the remainder of the beneficiary's life.
• Five-Year Rule: When the beneficiary is an estate, trust or charity, it has to pull out the full value of the contract within five years of the annuitant's death. It can do so through incremental withdrawals or with a lump sum disbursement.

Please note that these relate solely to nonqualified annuities.

Tax Implications

The taxes associated with an inherited annuity are similar to those of the annuity owner during their lifetime. Taxes are typically deferred until a withdrawal is made.

If the annuity was purchased with after-tax money (i.e., it's a nonqualified annuity), the recipient must pay income tax on the difference between the contract's current value and the cumulative value of the premium payments. However, the entire withdrawal from a qualified annuity — one bought with pretax dollars — is subject to ordinary income tax.

How you choose to receive disbursements will affect the timing and amount of your tax liability. Typically, taking a lump sum withdrawal will create the largest tax liability. Plus, the income tax has to be paid in the same year you received the money.

A nonqualified stretch will typically affect your tax bill the least, and it allows the beneficiary to spread the tax payments over the course of their lifetime.

Because annuities have so many options that can impact the financial well-being of your beneficiary and what happens to an annuity when you die, it can help to talk with a financial representative.