How do annuity death benefits work

Annuities are a popular way to turn part of a person's retirement savings into a stream of steady income to live on in retirement. Unlike other kinds of investments – like stocks or bonds – an income annuity is actually a contract with an insurance company: you provide them with a sum of money, and they turn it into a stream of guaranteed¹ payments that lasts a set number of years, or even the rest of your life. And since it's impossible to predict how long a given individual will live, some people can end up getting more from their guaranteed payments than the amount they paid in. However, depending on the options chosen, annuity payments could stop when the annuity owner dies, and the contracts place other limits on how funds can be accessed. That's why some annuities include a death benefit provision. This article will tell you about:

• How annuity death benefits work

• Common death benefit variations and options

• Tax implications and other considerations

What is a death benefit in an annuity?

Simply put, an annuity death benefit guarantees¹ a certain payment to beneficiaries when the annuitant – the individual whose life expectancy is used to calculate payments – passes away. The death benefit payment is typically either a specific pre-determined amount, or the remaining value of the annuity contract. Annuity death benefits serve as a form of financial protection for loved ones, ensuring that at least a portion of the annuity's value can be passed on to heirs.

NOTE: The annuitant and the owner of the annuity contract can be two different individuals. The owner is the person who purchases the annuity and holds the contractual rights, while the annuitant is the individual whose life expectancy is used to calculate annuity payments and death benefits – and that is how the term is used in this article. The owner can designate a different individual as the annuitant, and in such cases the death of the annuitant is what triggers the death benefit. It's important to understand the terms and conditions laid out in the specific annuity contract, as this will determine how the death benefit is triggered and paid out.

How annuity death benefits work 

Determining the death benefit amount

The annuity contract should state exactly how the death benefit amount is calculated. In some cases, the death benefit may be a fixed amount – for example, equal to the original investment amount. In other cases, the death benefit amount may vary, for example, because it is based on the annuity's "present value" (the current value of future payments from the annuity) at the time of the annuitant's death. The annuity's specific features and added additional riders or options can also affect the death benefit payout. As you purchase an annuity, it's important to ask your financial professional to spell out exactly how the death benefit will be calculated in different scenarios and points in time.

The type of annuity can affect how the death benefit is calculated

There are two basic types of income annuities: immediate and deferred. An immediate income annuity starts paying income right after you buy it, so the death benefit may vary accordingly. Some immediate annuities offer an option to guarantee¹ that the beneficiary will continue to receive payments for a certain period.

A deferred income annuity doesn’t start paying right away, which lets you build funds for a number of years before annuitization (the conversion of the annuity to a stream of income). There are typically different formulas for determining the death benefit if the annuitant dies before annuitization, or after income payments start. After all, if the annuitant has been taking income for several years, the annuity has less value.

There are also different ways for assets to grow in a deferred annuity. A fixed annuity pays a fixed interest rate, so you can predict its value at any point in the future. A variable annuity lets you invest and take advantage of the highs (and lows) of the financial market. An indexed annuity provides the potential for growth tied to a specific index, such as the S&P 500. Since the future value of a variable or indexed annuity can’t be predicted, you also can’t know the exact value of a death benefit based on that value. But depending on the specific annuity, certain options and features may be available to give you a better sense of what the minimum death benefit would be at a given point in the future.

Riders² and other features can affect the death benefit

Annuity contracts often offer riders (optional features) that can enhance the death benefit. For example, the "Guaranteed Minimum Death Benefit," or GMDB, is a common option that can ensure beneficiaries receive a minimum amount regardless of the annuity's performance. Other death benefit options may include:

1. Standard Death Benefit

Generally speaking, this is either a fixed sum or the current contract value, paid directly to the designated beneficiaries after the annuitant's death. Beneficiaries can usually choose to receive the funds as a lump sum or opt for periodic payments.

2. Return of Premium

With this option, if the annuitant dies before receiving annuity payments equal to the total premiums paid, the beneficiary will receive the difference as the death benefit. This ensures that the principal investment is protected even if the annuitant passes away just after annuitization.

3. Stepped-up Benefit

This type of rider can increase the death benefit over time. The annuity contract specifies a predetermined growth rate that is applied to the original investment, potentially resulting in a larger death benefit for the beneficiary.

4. Guaranteed Increase

This works similarly to the stepped-up benefit but guarantees a certain growth rate over a specific period, regardless of the annuity's performance. This can provide additional security to the beneficiary.

Tax implications and other considerations³

The death benefit in a life insurance policy, such as term or whole life insurance, is almost always paid out as a income tax-free lump sum. Annuities are different, and the tax treatment of their death benefits depends on the type of annuity, the age of the annuitant at the time of death, and other factors. But generally speaking, with "non-qualified annuities" (those purchased with after-tax dollars), beneficiaries only pay taxes on annuity earnings. With "qualified annuities" (those purchased with pre-tax dollars, like in a retirement account), the death benefit is typically taxed, either as ordinary income or via inheritance taxes. In any case, you should always speak with a tax consultant to ensure the death benefit and other annuity provisions are consistent with your needs and expectations.

Naming a beneficiary

As an annuity owner, you can name one or more beneficiaries to receive the death benefit. Beneficiaries can be people, such as family members or close friends, but they don't have to be. Charitable organizations and trusts are also commonly named as beneficiaries. Whoever you choose to designate, it's important to ensure that the beneficiary information is kept up to date with the insurance company that issues the annuity contract.

If you want to change or update your beneficiary designations, you should be able to easily do so by contacting the insurance company or financial professional who sold you the annuity. Regularly reviewing and updating beneficiary information will ensure that the annuity death benefit will be paid out according to your wishes.

What if you don’t want or need an annuity death benefit?

It's important to note that while optional death benefit provisions are commonly added to annuities, they don't have to be. If you don't have heirs you want to leave assets to, or their financial needs are being taken care of in other ways, you’re not required to elect an added death benefit – and in return, you'll typically benefit from lower fees or somewhat higher income payments.

Is an annuity appropriate for you?

An annuity can be an important part of your retirement planning strategy, and an added way to save money on a tax-deferred basis along with 401(k) plans, whole life insurance cash value, and other assets. But unlike those vehicles, it can guarantee¹ that no matter how long you live you won’t outlive all your retirement income. We suggest talking to a financial professional to see if a deferred annuity could be suitable for your needs.