3975 / How is a beneficiary taxed on life income or installment payments of a death benefit under a qualified plan when an employee dies before retirement?

If a beneficiary has no cost basis for the payments, each payment will be fully taxable as ordinary income when received. The beneficiary’s cost basis generally is the same as the employee’s cost basis ( Q 3973). In the case of decedents dying before August 21, 1996, the $5,000 death benefit exclusion was included in the beneficiary’s cost basis.¹

If the beneficiary does have a cost basis, payments are subject to the rules that follow, depending on whether the death benefits come from life insurance proceeds.

If death benefit payments do not come from life insurance proceeds, the beneficiary is taxed as the employee would have been taxed had the employee lived and received the periodic payments ( Q 3968, Q 3969). The beneficiary’s cost basis, rather than the employee’s cost basis, is used. Depending on the annuity starting date, an exclusion ratio may have to be determined; if so, the beneficiary’s cost basis is used as the investment in the contract (for an explanation of the basic annuity rule and its application to various types of payments see Q 527 to Q 552). For annuities with a starting date on or before November 19, 1996, if a beneficiary elected the simplified safe harbor method for taxing annuity payments ( Q 613) and increased the investment in the contract by any employee death benefit exclusion allowable, the beneficiary had to attach a signed statement to his or her income tax return stating that the beneficiary was entitled to such exclusion in applying the safe harbor method.² After such date, if the annuitant is under age 75, the simplified method is required, rather than optional.³ When more than one beneficiary is to receive payments under a plan, the cost basis, including the $5,000 exclusion, if available, is apportioned among them according to each beneficiary’s share of the total death benefit payments.