Annuity death benefit: How to decide if it’s right for your loved ones

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An asset that outlasts you.

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You may think of annuities in terms of the benefits they offer while you’re alive, such as a guaranteed stream of lifetime income. And although that’s why many retirees elect to purchase annuities, there’s another advantage to consider: death benefits.

Annuities are sold by insurance companies, so it’s not surprising that many annuity contracts include a death benefit payable to your beneficiaries when you die—not unlike life insurance. But not all annuities feature a death benefit. In some cases, if you want to add one, you’ll need to purchase an annuity rider.

Several factors come into play when the annuity owner dies. If the contract has been annuitized into a series of monthly payments, the payments would end if the owner (sometimes called the annuitant) had elected a single-life annuity—a type that pays you only as long as you live. In other cases, such as with a joint and survivor option or life with a period certain (a stipulated number of years), the payments can continue.

If the contract owner dies before annuity payments begin, the annuity’s remaining value often passes to the beneficiaries named in the contract. The amount they inherit depends on the terms of the contract.

An annuity death benefit is a payment made to the beneficiaries of an annuity contract following the owner’s death. The document stipulates how the benefit works, including how it is to be paid—whether as a lump sum or annuitized. Note that not all annuity contracts have death benefits.

When the contract owner dies before the contract is annuitized, the standard death benefit is often a lump sum. In this scenario, the beneficiaries receive the value of the premiums in the account plus the accumulated earnings. Depending on the terms of the contract, the insurance company may deduct certain fees from the benefit.

Earnings (i.e. capital gains and interest) included in the payout in a nonqualified annuity—an annuity funded with after-tax dollars—are taxable.

If the contract owner had annuitized the contract and was taking payments, there are several possible options for the death benefit.

Single-life annuitization. If the contract owner had chosen a single-life annuity, then all payments cease when they die. The value of any assets left in the contract revert to the insurance company. This annuitization option generally results in the highest annuity payments; it’s usually taken if the contract owner has no immediate family or has ample assets outside the annuity to go to a spouse or other heirs.

Joint and survivor annuitization. With this contract, the survivor continues to receive a benefit for the remainder of their life, even if the annuitant dies. Joint and survivor annuities may provide 100%, 50%, or some other amount of the benefit to the surviving annuitant. The higher the percentage of the benefit that goes to the survivor, the lower the initial amount of the annuity payments.

Typically, all payments cease upon the death of the surviving annuitant. In some cases, there might be a death benefit rider available that allows for a death benefit to be paid upon the death of the second annuitant.

Life with period certain annuitization. This option provides annuity benefits for a lifetime, but whether payments continue and to whom they are paid depends on how much time has passed.

For example, if the annuitization period is life with a period certain of 20 years and the contract owner dies after 15 years, the beneficiaries receive annuity payments for the remainder of the period (five years). After that, payments cease. If the contract owner dies after 22 years, the payments cease upon death.

A variation of this option is annuitization with a period certain only. With this selection, the annuitization for the contract owner lasts for a designated period. Using 20 years as an example, if the contract owner is the annuitant (the person covered by the annuity) and lives for 20 years or longer, then payments cease at the 20-year mark. If they die in year 17, their beneficiaries receive the remainder of the annuity payments until the 20 years have ended.

Life with refund annuitization. Under this scenario, the insurer guarantees that either the contract owner or their beneficiaries receive an amount that is at least equal to the amount of the premiums that the contract owner paid into the contract.

Death benefit riders. In some instances, a given contract may not include a death benefit. You may be able to purchase a death benefit rider, if available.

When a qualified annuity is held inside a retirement account like a traditional individual retirement account (IRA) or 401(k), the death benefit is taxed like any other distribution. With a nonqualified annuity, any earnings on the death benefit are taxed.

Inherited, nonqualified annuities are taxed based on the amount considered to be gains inside the annuity. Taxation varies if you choose a lump sum or periodic distributions.

Annuity death benefits vary from contract to contract and add another level of complexity to the already complicated nature of annuities. Understanding how death benefits work is key when purchasing an annuity contract, as is informing your beneficiaries. But don’t feel you have to go it alone. A financial advisor can help you determine whether an annuity contract is right and if you need any add-ons. And make sure you understand how much each add-on will cost you in terms of either up-front fees or reduced payments.

Knowing whether you’re leaving the legacy you intend and that your heirs are adequately provided for may be your best guide in making your choices. If you already have ample assets incorporated into your estate plan, an annuity without a death benefit may be the right choice, particularly if you have purchased life insurance.