528 / How are annuity payments taxed to a beneficiary if an annuitant under a life annuity payout with a refund feature dies and there is value remaining in the refund feature?

If proceeds under the refund feature are taken by the beneficiary either as a lump sum or in accordance with the annuity payout option under which the annuitant’s payments were calculated, proceeds will be excludable from income until the total amount the beneficiary receives, when added to the amounts received tax-free by the annuitant, is equal to the annuitant’s “investment in the contract,” unadjusted for the value of the refund feature.¹ This “FIFO” (first-in, first-out) basis-first treatment of beneficiary payments is different than the income/gains-first treatment applying to “amounts not received as an annuity” and from the “regular annuity rules” treatment that normally applies to annuitized payments.

If the total payments thus made to the beneficiary are less than the annuitant’s investment in the contract and the annuitant’s annuity starting date was after July 1, 1986, the beneficiary may take an income tax deduction for any such unrecovered investment.²

1. Treas. Reg. § 1.72-11(c).