545 / If an annuitant dies before receiving the full amount guaranteed under a refund or period-certain life annuity, is the balance of the guaranteed amount taxable income to the refund beneficiary?

The beneficiary will have no taxable income until the total amount the beneficiary receives, when added to amounts that were received tax-free by the annuitant (i.e., the excludable portion of the annuity payments), exceeds the investment in the contract. In other words, all amounts received by the beneficiary under a refund guarantee are treated as a return of principal first, and are exempt from tax until the investment in the contract has been recovered tax-free. Thereafter, receipts (if any) are taxable income. For purposes of calculating the unrecovered investment in the contract, the value of the refund or guarantee feature is not subtracted.¹ This “FIFO” treatment, for payments made to the beneficiary, is different from the “regular annuity rules” treatment that applied to payments made to the deceased annuitant.

The amount received by the beneficiary is considered paid in full discharge of the obligation under the contract in the nature of a refund of consideration and therefore comes under the cost recovery rule regardless of when the contract was entered into or when investments were made in the contract.² This rule applies whether the refund is received in one sum or in installments made under the same payout arrangement under which the deceased annuitant had been receiving payments.

If the refund or commuted value of remaining installments certain is applied anew under a different annuity option for the beneficiary, the payments will be taxed under the regular annuity rules. A new exclusion ratio will be determined for the beneficiary.³

If the refund beneficiary of an annuitant whose annuity starting date is after July 1, 1986 does not recover the balance of the investment in the contract that was not recovered by the annuitant, the beneficiary may take a deduction for the unrecovered balance ( Q 567).⁴