One of the benefits of a deferred annuity (an annuity contract in which regular annuity payments need not begin in the first year) is tax deferral (annual increases in cash value are not taxed as earned, but only when distributed). But this tax treatment may not continue in perpetuity; the contract value must be paid out as a death benefit when someone dies. But who is that someone? And which death benefit (for a contract may provide for more than one death benefit) will be paid? The answer to both questions is "it depends on the type of contract."
"Owner-Driven" vs. "Annuitant-Driven"
With regard to when a death benefit will be paid, there are two types of deferred annuity contracts. "Annuitant-driven" contracts will pay a death benefit upon the death of the primary annuitant (see footnote * below). "Owner-driven" contracts pay a death benefit upon the death of the contract owner (who may not be the primary annuitant). This would likely lead a normal English-speaking person to conclude that any given deferred annuity contract is either one or the other. That would make sense, but it's not the case. In fact, all deferred annuity contracts issued since Jan. 18, 1985 must be paid out upon the death of any owner because IRC Section 72(s)(1)(B) requires it. Some deferred annuity contracts are also annuitant-driven (that is, they will pay out upon the death of either an owner or the primary annuitant).
As if this were not complicated enough, the amount of such payout could be different if the contract provides a guaranteed minimum death benefit. Although conventional fixed deferred annuity contracts typically provide for only one death benefit (the cash value–which may or may not be subject to surrender charges), indexed and variable deferred annuities often contain a guaranteed minimum death benefit that may exceed the cash value. Thus, the amount paid out at death will depend upon (a) the identity of the decedent (was it the annuitant or an owner?) and (b) whether the contract provides for a guaranteed minimum death benefit.
Obviously, none of this is relevant if the owner and annuitant are the same individual, but this is not always the case. Sometimes, the owner and annuitant must be different parties (e.g., where the annuity is to be owned by a trust, which, not being a human being, cannot be the annuitant). Sometimes, the owner and annuitant are different parties because the individual named as owner could not be named as annuitant (e.g., some insurers will not issue a deferred annuity on an annuitant over a certain age, but will permit that person to be the owner, so long as a younger person is named as annuitant).
When possible, I strongly suggest that the owner and annuitant be the same individual, to avoid confusion. When this is not possible, or where there are good reasons for naming, as contract owner, someone other than the primary annuitant, everyone involved should understand what amount will be paid upon the death of either party.
*The annuitant in an annuity contract is the individual (it must be a human being) who is the "measuring life" of the contract, the person whose age and sex (for sex-distinct contracts) determines the amount of each annuity payment.
Some Illustrations
These examples assume that the contract is a deferred annuity where death occurs prior to the Annuity Starting Date. Immediate annuities and deferred annuities where death occurs on or after the Annuity Starting Date (that is, where regular annuity payments have already commenced) must be paid out "at least as rapidly as" the owner or annuitant was receiving them.
Example No. 1:
George owns an annuity that provides for payment upon the death of the annuitant (that is, the contract is "annuitant-driven"). George's wife, Gracie, is named as annuitant.
A. If the contract includes a guaranteed minimum death benefit,
- Gracie's death will trigger payment of that guaranteed minimum death benefit, because the contract is annuitant-driven.
- George's death will trigger payment of the contract's cash value (which may be less), because IRC Section 72(s) requires same.
B. If the contract does not provide for a guaranteed minimum death benefit,
- Gracie's death will trigger payment of the cash value (the "regular" death benefit, there being no guaranteed minimum death benefit other than the contract's cash value), because the contract is annuitant-driven.
- George's death will trigger payment of the contract's cash value, because IRC Section 72(s) requires same.
Example No. 2:
George owns an annuity that provides for payment upon the death of the owner (that is, the contract is not "annuitant-driven"). Gracie is named as annuitant.
A. If the contract includes a guaranteed minimum death benefit,
- George's death will trigger payment of that guaranteed minimum death benefit.
- Gracie's death will trigger no payout. George can simply name a new annuitant. (Many contracts will, in that situation, cause George, as owner, to become the new primary annuitant).
B. If the contract does not provide for a guaranteed minimum death benefit,cash value.
- George's death will trigger payout of the contract's cash value.
- Gracie's death will trigger no payout (as above).
When a Deferred Annuity Is Owned by a Trust
