Annuity Traps (Part 2) - Rodgers & Associates

Annuity Traps (Part 2)

Mouse Trap

Last month, we began a discussion of annuities. Specif­i­cally, the traps people fall into because they or their adviser don’t fully under­stand how annuities work. An annuity is an insurance product sold by financial insti­tu­tions and is designed to grow funds, tax-deferred, until the money is withdrawn. Last month, we discussed living benefits and the problems that can be created while the owner of the contract is alive. This month, we will focus on problems that can crop up once the owner of the contract dies.

Annuity Traps Part II – Death Benefits

Let’s start with some defin­i­tions. There are three parties to every annuity contract – the owner, the annuitant, and the benefi­ciary.

The owner controls the contract. The owner has the right to add and withdraw money, change parties to the annuity and terminate the contract.

The annuitant is similar to the insured in a life insurance policy. The annuitant, unless he or she is the contract owner, has no say in or control of the annuity contract. The annuitant does not have the power to make withdrawals, deposits, change the names of the parties to the agreement, or terminate the contract. The only quali­fi­cation is that the named annuitant is a person currently living who is under a certain age. The maximum age of the proposed annuitant depends on the insurance company. Most annuities allow the contract owner to change the annuitant at any time. The annuitant is the individual named under the annuity contract whose life will serve as the measuring life for purposes of deter­mining benefits to be paid out under the contract. According to the Internal Revenue Code, the annuitant is the individual whose life is of primary impor­tance in affecting the timing or amount of the payout under the contract. The annuitant and the owner can be one and the same.

The benefi­ciary is like the benefi­ciary of a life insurance policy. The death benefits of the annuity contract are paid to the benefi­ciary when another party to the annuity contract dies. The benefi­ciary has no rights under the annuity contract, other than the right to receive payment of the death benefit. Likewise, the benefi­ciary cannot change the payout settlement option, alter the starting date for benefit payments, and cannot make any withdrawals or partial surrenders against the contract.

According to the Internal Revenue Code, the death benefits of an annuity contract are triggered upon the death of the owner. If the contract has joint owners, the annuity is still required to begin making distri­b­u­tions upon the death of any owner. We often find annuities held jointly between husband and wife with the children named as benefi­ciary. When one of the spouses dies, the proceeds of the contract are paid out to the children. In nearly every case I’ve seen, this is not the intention of the parents. It is extremely important that you make sure your annuity contracts are titled properly. If the design is for the annuity to benefit a surviving spouse, then one spouse should be named owner and annuitant and the other named as benefi­ciary. The children can be named as contingent benefi­ciary in the event both spouses die at the same time.

The Five-Year Rule

Distri­b­u­tions at death must be completed by the fifth anniversary of the date-of-death of the owner. This is similar to the IRA distri­b­ution rule at death with the important exception that the five years begins with the date-of-death. IRA benefi­ciaries have five years beginning from December 31st of the year that death occurs. The proceeds can be distributed in any fashion during the five year period. For tax purposes, distri­b­u­tions are considered earnings first and principal last. The earnings will be taxed to the benefi­ciary as ordinary income.

There are two excep­tions to the five-year rule:

1) The benefi­ciary has the option of taking the distri­b­u­tions equally over their life expectancy. In order to be able to elect this option, the benefi­ciary must be named in the contract. They cannot be assigned as benefi­ciary by the executor. When the benefi­ciary chooses this option the payments are considered part principal and part earnings for tax purposes. The actual ratio is calcu­lated based on the principal in the contract divided by the number of expected payments. The payments must begin within one year of the date-of-death and the benefi­ciary must be a person; not an entity. If a trust is named as the benefi­ciary, it must follow the five-year rule.

2) When the named benefi­ciary is the spouse of the deceased owner, they can elect to continue the contract without taking distri­b­u­tions. Essen­tially, they take control of the contract as if they were the owner. Some insurance companies have restric­tions on the amount of control the spouse can exercise if they choose to continue the contract in force. You should check the terms of the contract to determine what restric­tions may apply. This election can only be made when the spouse is the named benefi­ciary in the contract. When the spouse benefi­ciary dies, the normal rules for distri­b­u­tions to the contingent benefi­ciary will apply. The IRS has made private letter rulings allowing spousal contin­u­ation of annuities when the spouse’s revocable living trust has been named as the benefi­ciary.

Deduc­tions for Estate Tax

The entire value of the contract is included in the estate of the deceased and may be subject to federal estate tax. The deferred earnings in the contract are taxable to the benefi­ciary as ordinary income. The benefi­ciary is entitled to deduct the amount of estate tax paid on the contract from his tax return to avoid double taxation. This deduction is known as Income in Respect of a Decedent and is probably one of the most frequently missed deduc­tions. Keep in mind that this only applies to federal estate tax and not state inher­i­tance tax. Furthermore, estates are currently only subject to estate tax when they exceed $5 million.

Annuities at death are like other types of retirement accounts in that all of the deferred income is passed on to the benefi­ciary and will be taxable when withdrawn. There is one exception. Annuity contracts that were issued before October 21, 1979 and are still in force at the death of the owner get a stepped up cost basis. This means the benefi­ciary will receive all the earnings tax free. This is a rare situation, but one to be aware of before cashing in an old policy.


Annuities may be an important tool for building wealth but they are not for everybody. While they are very similar to IRAs and other types of retirement accounts, annuities have a unique tax structure of their own. Individual insurance companies often have unique rules for their specific contracts which complicate the situation even more. Make sure you have all the infor­mation before you purchase a contract. Each individual’s circum­stances are different and there are no pat answers. If you already own an annuity, have it reviewed by a financial planner who under­stands the issues regarding annuities and make sure you have your contract titled properly. Many problems can be addressed and remedied while the contract owner is still living.