A spouse inherits an annuity: continue it, cash out or take payments

Three weeks after the funeral, a packet arrives from the insurance company that issued your late husband's annuity. It has a claim form, a page of "beneficiary options" and a letter that says you must choose. Nothing in the packet says which option is best, because the insurer cannot know. The right answer depends on your age, your need for cash, your tax situation and whether you want the money to keep growing.

This post follows four hypothetical households through the same decision. The people and figures are invented to show the mechanics, and a tax professional should apply the rules to a real return. The general rules are in the guide on annuity beneficiaries and inherited annuity options; here, the focus is on what the choices look like in dollars and paperwork.

The three paths, in plain terms

When the owner of a deferred annuity dies and the surviving spouse is the named beneficiary, the spouse generally has three broad routes:

1. Continue the contract. Under the federal tax rules for non-qualified annuities, a spouse who is the designated beneficiary can be treated as the new owner. The contract keeps going, the gain stays tax-deferred and the spouse takes withdrawals when and as they choose. Insurers call this spousal continuation.
2. Take a lump sum. The insurer pays out the death benefit in one payment. The gain is taxed in that year.
3. Take payments. The spouse converts the death benefit into a stream of payments, for life or for a period of years, using annuitization. The gain is spread out over the payments.

Two facts apply to all three. First, annuities do not receive a step-up in basis at death, the way stocks or real estate may. The cost basis, or the premiums the owner paid, passes to the spouse, and the gain is still waiting to be taxed. Second, the contract controls what is offered. Some insurers offer all three routes, some limit them, and the details of timing and defaults differ. The tax rules set outer limits, and the insurer's forms and deadlines sit inside them.

Household A: Ruth, 61, continuing the contract

Dan, who was 64, owned a non-qualified deferred annuity. He paid $150,000 of after-tax premiums, and at his death the contract is worth $210,000, so $60,000 of gain has not been taxed. Ruth, 61, is the sole primary beneficiary. She works part-time and does not need the money now.

What she does. Ruth elects spousal continuation. She becomes the owner, names her own beneficiaries and keeps the contract. Her basis is Dan's $150,000, and the gain stays deferred. She takes nothing now.

What the numbers show. If Ruth had taken a lump sum instead, $60,000 of gain would be taxable in the year of payment. At an illustrative flat 22% for round numbers, that would be $13,200. Real federal rates are graduated, so adding $60,000 to one year's income could be taxed at more than one rate. With continuation, there is no tax now, and the gain can keep growing.

What to watch. Continuing has costs. Ruth is now the owner, and the tax rules treat later withdrawals as hers. Because she is over 59½, there is no additional 10% tax on early withdrawals, but if she were 55, she would face it on gain withdrawn before 59½. The blog post taking annuity money before 59½: when the 10 percent tax applies explains that rule. She should also check whether continuation resets a surrender period or removes any death benefit feature, since contracts differ. And she now bears the same issues Dan faced: fees, the insurer's financial strength and the eventual tax on gain. Her heirs will face the gain, too, because there is no step-up for them either.

The paperwork. Typical steps: certified copies of the death certificate, the insurer's claim or continuation election form, proof of her identity, a new beneficiary designation for the continued contract and, in some cases, a tax form. Ask the insurer what its default is if she does not respond. Some contracts continue the contract automatically for a spouse; others pay a lump sum or start a five-year clock unless she elects.

Household B: Derek, 48, taking a lump sum

Aisha, who was 46, left a non-qualified annuity worth $90,000, built from $70,000 of premiums, so the gain is $20,000. Derek, 48, is the sole beneficiary. He has a mortgage and two children, and Aisha's income is gone.

What he does. Derek takes the $90,000 as a lump sum, subject to the contract's rules on surrender charges at death, which many contracts waive (the claim packet or the contract will say whether his does).

What the numbers show.

• Cash received: $90,000
• Basis returned tax-free: $70,000
• Taxable gain: $20,000, as ordinary income
• At an illustrative 22%: $4,400
• Additional 10% tax: none, because distributions after the owner's death are generally an exception to the early-withdrawal tax, even though Derek is under 59½.

Now compare the alternative. If Derek had continued the contract and later withdrawn the gain before 59½, the 10% tax could apply to it: 10% × $20,000 = $2,000, on top of income tax. That is the reason a younger spouse who needs the money sometimes takes the death benefit rather than continuing.

What to watch. The payout year's tax return may look different from earlier ones. A spouse can often file a joint return for the year of death. In later years, Derek's filing status may change, which can change the tax on the same gain. A tax professional can estimate the numbers before he chooses a year to receive the payout, where the insurer's timeline allows a choice. Insurers also generally withhold federal income tax at a default rate on a lump sum, which may be less than he owes, so he should plan for the difference.

The paperwork. The claim form, the certified death certificate, identification, a tax form so the insurer can report the payment, and payment instructions. Derek should ask for the breakdown of basis and gain in writing, so that the 1099-R he receives later matches.

Household C: Lena, 66, choosing payments

Her husband Carl, 68, owned a non-qualified deferred annuity worth $160,000 on a $100,000 premium, so the gain is $60,000. Lena, 66, is the beneficiary. She has Social Security but wants a predictable supplement, and she does not trust herself to manage a large lump sum.

What she does. Lena elects to annuitize the death benefit, taking monthly payments for her lifetime. The insurer quotes $900 a month. This is an invented figure; real payments depend on the insurer's rates, her age and the option she chooses.

What the numbers show. The payments are taxed using the exclusion ratio. Suppose the insurer's expected return comes to $200,000.

• Annual payments: $900 × 12 = $10,800
• Exclusion ratio: investment in the contract $100,000 ÷ expected return $200,000 = 50%
• Tax-free per year: $5,400. Taxable per year: $5,400.

If Lena lives long enough to recover the $100,000 of basis, which takes about 18.5 years at $5,400 a year, the payments become fully taxable from then on. The post the exclusion ratio: how annuitized payments split into basis and gain works through the split in detail.

The trade-offs. Payments give her income she cannot outlive, with some tax spread over many years. But annuitization is usually irrevocable. If she chooses a life-only payout, nothing passes to her children when she dies. If she adds a period-certain feature, the payment is lower but the children may receive the remainder. Lena also gives up access to the lump sum for emergencies. She should compare the quote with a quote she can get from the same insurer for the same amount elsewhere, and ask a fee-only planner whether a mix works better, such as taking part as payments and continuing part as the contract. Not every insurer allows a split.

The paperwork. An annuitization election form with the payout option marked clearly, the usual death claim documents and proof of age. The tax rules require that life-expectancy payments to a beneficiary start within one year of the owner's death, so the election has a time limit in addition to the insurer's own deadline.

Household D: the annuity that named someone else

The last household shows a case where the spouse has fewer choices. Tom owned a non-qualified annuity worth $120,000 and named his son Marcus as the beneficiary years ago, before he remarried. Tom's wife Sue assumed the annuity would pass to her.

What happens. The beneficiary designation controls, not the marriage and not the will. Marcus, a non-spouse, is the one with the claim, and he does not have the spousal continuation option. The post on the child's side, a child inherits an annuity: the payout windows non-spouse heirs face, explains the choices and deadlines he faces. Sue has no claim to the annuity unless the contract is owned jointly or a state law or court order gives her one.

What to take from it. If you are Sue, ask the insurer for a copy of the beneficiary designation, rather than guessing. If you are Tom, review the form after every major life event, as the guide on how to change your life insurance beneficiary explains. And if the annuity sits inside an IRA, a different set of rules applies: a spouse in that case may be able to roll the money into her own IRA, which is a separate decision covered in the guide on annuity beneficiaries and inherited annuity options.

The same contract, three ways

To see the routes side by side, take Ruth's contract from Household A: $210,000 of value, $150,000 of basis and $60,000 of gain, and ask what each route would do, setting aside growth and fees.

No row is better than another in the abstract. The table only shows that each route trades one kind of flexibility for another, and that the tax does not disappear in any of them.

Slips that cost spouses money

Several errors come up often in claims for spouses.

• Letting a default decide. A packet that sits unopened for weeks can run past an election deadline, and the contract's default may not be the option you would have picked. Open the packet, find the deadline and call if it is unclear.
• Assuming a step-up. Many surviving spouses expect that the gain disappears at death, as it can with stocks. For an annuity it does not, so the tax bill is still there.
• Spending before deciding. A payout is a one-way door. Money spent from a lump sum cannot be put back into the contract.
• Forgetting the joint return rules. Tax filing status can change after a death, and the same gain may be taxed differently in the payout year. This is a good question for a preparer before the year ends.
• Leaving the new beneficiary line blank. After continuation, the contract needs a new beneficiary designation. Without one, the money may go to the estate when the surviving spouse dies, with the problems the guide on what happens to an annuity when you die describes.
• Ignoring other documents. The annuity is one asset among several. The life insurance policies, retirement accounts and bank accounts each have their own claim process, and a calm order of tasks helps. The first days after a death are rarely the best time for a large irreversible decision, if the insurer's deadlines allow a pause.

A decision list

Here is a rough way to sort the choices, to bring to a conversation with a tax professional or fee-only planner. It is a prompt for discussion, not a rule.

• If you do not need the money and want to keep the tax deferred, continuation is the usual fit, especially if you are over 59½.
• If you need cash now and are under 59½, a lump sum may avoid the additional tax that later withdrawals from a continued contract could bring, at the cost of paying income tax on the gain in one year.
• If you want income you cannot outlive, annuitized payments fit, but consider the guarantees and the irrevocability.
• If you are unsure, ask the insurer how long you have to decide and what happens if you do nothing. Time to think is worth more than a quick choice.
• If the annuity is in an IRA or employer plan, the choices follow retirement account rules, and the answers above do not apply.

Questions to ask the insurer

1. Is the annuity qualified or non-qualified, and what is the cost basis?
2. What is the death benefit value, and are surrender charges or market value adjustments waived at death?
3. Which options does the contract offer to a surviving spouse, and by what date must I elect?
4. What happens if I do not respond by the deadline?
5. If I continue, does the contract keep its benefits and fees, and does a new surrender period start?
6. How will the payment be reported, and how much will be withheld?
7. If I take payments, which payout options are available, and which are irrevocable?

Keep each answer in writing. The state insurance department takes complaints if an insurer misstates your options.

Key takeaways

• A surviving spouse who is the named beneficiary of a non-qualified annuity can generally continue the contract, take a lump sum or take payments, and the contract and the insurer's forms set the details.
• There is no step-up in basis at death, so the gain stays taxable whichever route is chosen; the routes differ in when the tax arrives.
• A younger spouse who continues the contract and withdraws gain before 59½ can face the 10% additional tax that would not apply to a payout after death.
• Annuitized payments spread the gain using the exclusion ratio but are usually irrevocable, so the payout option matters.
• The beneficiary form controls who gets a choice at all, so confirm who is named before assuming anything.