Annuity Beneficiary Rules: Payout Options, Spouses and Taxes

What is an annuity beneficiary?

An annuity beneficiary inherits the contract’s death benefit. That is usually the account value, though some contracts guarantee at least the premiums paid minus withdrawals, or more through an optional rider. Most deferred annuities waive surrender charges when the death benefit is paid.

Three roles appear on every annuity contract, and mixing them up causes most beneficiary problems:

• Owner. Buys the contract, controls it, and names the beneficiary.
• Annuitant. The person whose life the income payments are based on. The annuitant is usually the same person as the owner.
• Beneficiary. Receives the death benefit. It can be one person, several people, a trust, an estate or a charity.

If the owner and annuitant are different people, check whether the contract is annuitant-driven or owner-driven. That decides whose death triggers the payout.

Annuity beneficiary payout options

When the owner dies before income payments start, federal tax law (IRC §72(s))^[1] gives a beneficiary a short list of choices. A contract can offer fewer options than the law allows, so read its death benefit section.

If income payments had already started when the owner died, the rest must be paid at least as fast as before. Period-certain and joint-life payouts keep going to the beneficiary or the joint annuitant.

Spouse vs. non-spouse beneficiary rules

A surviving spouse has more choices than any other annuity beneficiary. Everyone else must take the money out on one of the IRS schedules above.

On many contracts, spousal continuation applies only when the spouse is the sole primary beneficiary. If continuation matters to you, name your spouse alone as primary and your children as contingent beneficiaries.

How an inherited annuity is taxed

An inherited annuity does not get a step-up in cost basis the way inherited stock or a house does. The beneficiary owes ordinary income tax on the gain, meaning everything above what the owner paid in (IRS Publication 575^[2]). On a non-qualified annuity, the original premium comes back tax-free.

Death benefit payments are not hit with the 10% early withdrawal penalty, however young the beneficiary is. The penalty exception for payments made after the owner’s death is in the same section of the tax code.

Worked example: a $140,000 inherited MYGA

Say a parent paid $100,000 into a non-qualified MYGA that is worth $140,000 at death. The $100,000 of premium is tax-free to the child, and the $40,000 of gain is taxable income.

• Lump sum. All $40,000 lands in one tax year. At a 22% federal rate that is about $8,800 of tax at once, and a gain this size can push part of it into a higher bracket.
• 5-year rule. Spreading the gain over five tax years, about $8,000 a year, can keep it in a lower bracket. Withdrawals come out gain-first, the same way annuity withdrawals are taxed for owners.
• Life-expectancy payments. Each payment is part tax-free premium and part taxable gain, so the tax is spread over many years.

IRA and other qualified annuities

If the annuity sits inside an IRA, every dollar is usually taxable because the money went in pre-tax. Under the SECURE Act, most non-spouse beneficiaries must empty an inherited IRA within 10 years (IRS Publication 590-B^[3]).

Some eligible designated beneficiaries^[4] can still stretch payments over their life expectancy:

• Surviving spouses.
• Minor children of the owner, until they reach the age of majority.
• Disabled or chronically ill beneficiaries.
• Anyone not more than 10 years younger than the owner.

Naming a trust, estate or charity as beneficiary

A trust, estate or charity is not a person, so the IRS does not treat it as a designated beneficiary. For a non-qualified annuity that usually means the 5-year rule, with no lifetime stretch. Some contracts let a trust pass the payout through to its individual beneficiaries, so ask the carrier before you name one.

• Trust. Adds control, for example for a minor or an heir who overspends. It usually shortens the payout, and gain kept inside the trust is taxed at trust rates, which reach the top bracket quickly.
• Estate. Sends the annuity through probate, which is the delay a beneficiary designation exists to avoid.
• Charity. Pays no income tax on the gain, so it is often the most tax-efficient beneficiary for an annuity with a large gain.

Primary, contingent and multiple beneficiaries

• Primary beneficiary. First in line. You can name several and split the death benefit by percentage.
• Contingent beneficiary. Inherits only if every primary beneficiary has died or disclaims the inheritance^[5].
• Multiple beneficiaries. Many contracts let each one choose a payout option for their own share.
• No living beneficiary. The death benefit goes to the owner’s estate and through probate.

How to name or change an annuity beneficiary

You name a beneficiary on the application and change it with the carrier’s beneficiary change form. A will cannot override the beneficiary designation on the contract.

• Review after life events. Marriage, divorce, a birth or a beneficiary’s death are the usual triggers.
• Use full names and percentages. A vague designation like “my children” can cause disputes if a child dies first.
• Check spousal consent. In community property states, naming someone other than your spouse may require your spouse’s written consent.

Not sure who is named on your contract, or which payout options it allows? Send us your latest statement and we will confirm your annuity beneficiary and payout options at no cost.

This article is general education, not tax or legal advice. Talk with a tax professional about your situation.

Frequently Asked Questions