Annuity Contract – What Happens at the Death of the Owner?
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For any annuity contract issued after April 22, 1987, it must terminate upon the death of the owner and benefits will then be paid to the designated beneficiary. The death of any owner will trigger the termination of the annuity contract even when the contract is owned by a number of individuals – husband and wife. See Internal Revenue Code (“IRC”) § 72(s)(1). However, when a non-natural person owns an annuity contract, then the primary annuitant will be treated as the owner and the contract will terminate upon the death of the annuitant. See IRC § 72(s)(6).
If the death occurs before the annuity starting date (also known as annuitization), then a beneficiary must receive the entire interest within five years of the date of death of the owner. Satisfying the five-year requirement does not mean that payments must be received during this time. This requirement will be satisfied so long as the entire proceeds are received by the end of the five-year period; a single payment will suffice. There is an exception to the five-year requirement if the beneficiary elects to receive distributions stretched over the beneficiary’s life expectancy.
The life expectancy distribution requirement will only be met if distributions begin not later than one year after the death of the holder and are based on the life or life expectancy of the beneficiary. See IRC § 72(s)(2). Receiving an annuity for life will satisfy this exception and the exclusion ratio would be applied to each payment until such time as the entire basis has been recovered.
It is not, however, necessary to annuitize the contract in order to qualify for this exception. Systematic distributions based upon the life or the life expectancy of the beneficiary will also qualify for this exception. However, these payments will be treated as distributions and all gain must first be distributed before a distribution of basis will occur.
When the death occurs after the annuity starting date (the annuity contract was annuitized – structured into monthly payments), any remaining amount must be distributed to the designated beneficiary at least as rapidly as the method for receiving distributions prior to death.
If the owner’s spouse is the designated beneficiary of the annuity contract, then the surviving spouse may make an election to treat the annuity contract as his/her own. This affords the surviving spouse the option of continuing the contract as if it was his/her own contract, thereby continuing the tax deferral possibly until his/her own death, or receiving payments under one of the methods described above.