Is Variable Annuity Death Benefit Taxable?

You fund qualified annuities with pretax dollars, which makes their distributions taxable as income. As with any qualified plan, you or the inheritor will pay ordinary income taxes on any distributions. Investing in an annuity through a qualified plan offers you no additional tax deferment, as that is the defining characteristic of the annuity, even a nonqualified one. For this reason, some financial experts advise against investing in annuities within qualified plans.

The primary difference between the taxation of the death benefit of a nonqualified annuity and another investment, such as stocks, has to do with the step up in basis. When the cost basis of an investment is stepped up, the inheritor’s taxation is based on the adjusted value of the investment at the time of inheritance, not the value when it was originally purchased. So if you inherit stocks that were purchased 40 years ago for $5,000 but are now worth $50,000, your taxes will be based on how much the value increases beyond $50,000 when the stocks are sold, not their increase over the original $5,000.

Variable annuities are mutual funds wrapped inside an annuity. They offer the advantages of investing in mutual funds with the tax deferment of the annuity. If the accounts grow in value, your account pays out more than if they hold their value or decrease. Unlike a mutual fund, which benefits from the step up in value, the annuity does not. If you’re a non-spouse beneficiary, you pay ordinary income taxes on any deferred earnings -- increases above what the owner contributed -- from the annuity.

Many annuities allow spouses to take over the contract when the owner dies at either the contract or the death benefit value, whichever is higher. This establishes the greater death benefit and postpones the paying of taxes on the death benefit. The spouse pays ordinary income taxes when the funds are annuitized and distributed.

Annuities provide a standard death benefit, which amounts to the contract value or the amount of your purchase payments, less any withdrawals, whichever is greater. You can also add an enhanced death benefit for an additional cost, which lets you lock in the growth of your investments in the separate accounts or guarantees you a minimum rate on your account's value.