As we’ve seen, there are close parallels between the roles of the owner and insured under a life insurance contract and the owner and annuitant under an annuity. There are also some parallels between the roles of the beneficiary under these two contracts, but the purpose of the beneficiary is somewhat different under each contract. Under a life insurance contract, the beneficiary is the person to whom the benefits of the contract are primarily intended to flow. But the benefits of an annuity are designed to flow primarily to the owner and annuitant – the beneficiary is only a sort of remainder man designated to receive benefits after the owner or annuitant’s death.
The death benefit payable to the beneficiary of a deferred annuity prior to the annuity starting date is usually equal to the greater of either:
- the total premium paid for the annuity to date, minus any withdrawals, or
- the current accumulated value of the annuity fund
For variable annuities, this protects the beneficiary in case of declines in the financial markets. Under some variable annuities, item 2 above may be increased by crediting interest at the guaranteed rate.
Generally, no surrender charges or market value adjustments are applied in determining the amount of a deferred annuity’s death benefit.
Most variable annuities offer a “stepped-up” death benefit feature or “reset” under which gains achieved in the separate account investment options may be preserved for the purpose of calculation the death benefit even if the accumulated value later drops. The stepped-up death benefit is generally calculated with reference to the highest accumulated value recorded at certain intervals – for example, every third or every fifth policy anniversary. The stepped-up death benefit may also include any premiums paid (minus any withdrawals taken) since that time.
When the Death Benefit is Received Under Owner-Driven and Annuitant-Driven Contracts
One similarity between the life insurance and annuity contracts is that death is the event that triggers the payment of benefits to the beneficiary. However, with a life insurance contract, only one individual’s death is relevant: the insured’s. With an annuity, if the contract is owner-driven, payment of a death benefit is triggered by the death of the owner. In the case of an annuitant-driven contract, it will be triggered by the death of the annuitant, depending on how the pertinent provisions in the contract are worded. If the owner and the annuitant are the same person, this potential complexity doesn’t come into play.
Remember that, regardless of the type of contract, the value of the contract must be distributed or annuitized if an owner dies. This forced distribution is not the same as a guaranteed death benefit.
Change of Beneficiary
Most annuities reserve to the contract owner the right to change the beneficiary at any time during the annuitant’s life. However, some contracts give the owner the option of naming a permanent, or irrevocable, beneficiary. If an irrevocable beneficiary is named, the beneficiary designation can later be changed only with the beneficiary’s consent.
Spouse or Children as Beneficiaries
In most cases, the beneficiary is the owner’s spouse so that the spousal exception to the required distribution rules can be used to continue the contract in the event of the owner’s death. Sometimes it is appropriate for the owner to name his or her child or children as beneficiaries. If a beneficiary is a minor child, the owner should have a will and name a guardian to receive the benefits on the child’s behalf. The guardian should be named in the contract. Otherwise, the child’s lack of legal competence will likely cause the insurer to delay paying the benefits until a court appoints a guardian.
Non-natural Person as Beneficiary
In a few cases, it may be appropriate to name a trust or estate beneficiary under an annuity – a beneficiary need not be a natural person. If the proceeds are paid to a non-natural person as a required distribution upon the owner’s death prior to the annuity starting date, proceeds must be distributed within five years – the annuitization option will not be available, since the beneficiary is not a natural person.
More than one beneficiary can be named under an annuity. Most annuities provide that if more than one beneficiary is named, equal shares will be paid to each beneficiary unless the owner has specified otherwise.
Taxation of Beneficiary
Upon the annuitant’s death, the beneficiary becomes liable for income tax on any gain paid out of the contract.
Also, in some cases, the beneficiary may become liable for the 10% penalty tax on premature distributions. This is because of the way the definition of “premature distribution” is written in the tax law for annuities purchased on a non-qualified basis. For annuities purchased on a non-qualified basis:
- The definition of a premature distribution is written with reference to the taxpayer’s age. Upon the death of the annuitant, the beneficiary becomes the taxpayer rather than the owner.
- In addition, the distribution-at-death exception to the definition of “premature distribution” refers to the death of the contract owner, or to the annuitant only if the owner is not a natural person. If the owner and annuitant are different persons and the owner is a natural person, the distribution-at-death exception does not apply at the death of the annuitant.
Therefore, if an annuity is purchased on a non-qualified basis and the owner of the annuity is a natural person and is not the annuitant, the annuitant’s beneficiary will be liable for the 10% penalty tax if he or she receives taxable death proceeds from the annuity when he or she is under age 591/2.
The situation is not as unlikely as it may sound. Most annuities are purchased on a non-qualified basis, and if the husband of a married couple is the purchaser, he is likely to name himself owner. However, it is also common for a married couple to assume that the husband will die before the wife, since men have a shorter average life expectancy than women, so the owner may name his spouse as annuitant. And since it is assumed that the husband will have already died by the time the wife dies, the couple’s child or children may be named as beneficiary.
However, as we’ve already seen, depending on the provisions in the contract, if the wife dies first, the husband’s ownership rights may cease and the value of the annuity may be paid to the children. The surviving husband-owner will have to pay income tax on any gain existing in the contract at the time of the wife’s death. If the husband is under age 591/2, he may have to pay the 10% penalty tax. And if the children are under age 591/2, they’ll be liable for the 10% penalty tax as well as regular income tax on any future income paid out of the contract.
Having either the husband or wife be both owner and annuitant, and naming the other spouse beneficiary can obtain better results. Then regardless of who dies first, the spousal exception is available to continue the contract without income tax consequences. The children can be named as contingent beneficiaries in the event of a common disaster involving both the husband and wife.
Death of Beneficiary
The death of the beneficiary does not affect the contract itself. However, if the beneficiary dies before the owner or annuitant and a new beneficiary is not named, benefits may end up being paid to the owner’s or annuitant’s estate. If some other disposition is desired, the owner can name a contingent beneficiary to receive benefits in the event that the primary beneficiary is not living at the time benefits become payable.
Last Updated: 9/23/2012 10:05:00 PM