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Understanding Non-Qualified Death Claim Options ¹

The death of a loved one can be a challenging period for families, and it often requires careful decision-making. Beneficiaries will look to their financial professional for help determining how the death benefit will be distributed, a choice that can influence key factors like payment amounts and each beneficiary’s individual tax situation.

Since annuity gains are subject to ordinary income tax, this additional revenue can have implications for beneficiaries. It’s essential that they understand the available options and make an election by the anniversary of the date of death to comply with the rules set forth by the Internal Revenue Code.²

Benefits of Non-Qualified Stretch:

Income Tax Control: Beneficiaries only pay taxes on the amounts distributed annually. The balance remains in the annuity and has the potential to grow  tax deferred.

Flexibility: Beneficiaries may take withdrawals in addition to the required amount. Additional distributions are taxable in the year distributed, may impact future annual distributions and may be subject to a surrender charge.

Leaving a Lasting Legacy: Beneficiaries receive payments for as long as there is a Contract Value. In the event of a beneficiary death, the payouts can be transferred to their named beneficiary. The payouts must continue based on the original beneficiary’s remaining IRS life expectancy factor or be paid in a lump sum.³

For individual beneficiaries of non-qualified annuities (annuities not inside an IRA or Qualified Retirement Plan), there are five payout options available for non-spouse beneficiaries,⁴ with a sixth reserved for spouses. In the case of multiple named beneficiaries, each beneficiary may make their own election:

Lump Sum

The entire death benefit is received in the year the claim is made.
Income to the beneficiary is taxed to the extent attributable to gain on the contract.

Annuitization

Annuitized distributions must start no later than one year after the death of the owner.
Distributions will receive an exclusion ratio, where part of the payment is return of principal and part of the payment is gain.
Annuitization is irrevocable and generally lacks the flexibility to take additional withdrawals.

5-year Deferral

The beneficiary must liquidate their portion of the contract by the fifth anniversary of the date of death of the annuity’s owner.
Discretionary withdrawals may be distributed at any time during the five-year period or the beneficiary may wait until the fifth year to liquidate the entire annuity proceeds. This may be subject to contract provisions.
Distributions to the beneficiary are taxed on a Last-In, First-Out (LIFO) basis, meaning taxable earnings are treated as distributed before any tax-free return of principal.
If a beneficiary makes no election prior to the anniversary of the date of death, the five-year deferral will be the default method.

Non-Qualified Stretch

The beneficiary may “stretch” the death benefit from a deferred annuity over their  own life expectancy. The beneficiary must take the Required Minimum Distribution at least annually, starting no later than the anniversary of the date of death of the owner. See the Life Expectancy Table for the full listing of first year payout factors by age.⁵
Stretch payments satisfy IRS requirements while offering greater flexibility and control, including the ability to take additional withdrawals (subject to contract provisions).⁶
Taxes are payable by the beneficiary only on the amounts distributed annually. Distributions are taxed on a LIFO basis.
Assets not withdrawn will remain in the annuity and have the potential to grow tax deferred.
The beneficiary has ownership rights and   may determine the annuity product and how it is allocated.⁷

Beneficiary 1035 Exchange

If allowed by the surrendering carrier, a beneficiary may elect to 1035 exchange their death benefit to a new contract with features and benefits that align with their goals.⁸
The beneficiary would move the annuity into a contract at another carrier that matches the death claim distribution option chosen at the time of death. Distribution requirements remain unchanged at the new carrier.

Spousal Continuation

If the spouse is the sole beneficiary, they can choose spousal continuation. The spouse may assume ownership of the annuity contract instead of receiving a payout and the annuity keeps its tax-deferred status. If elected, income payments may continue as originally planned.

By understanding these options, beneficiaries can select the path that better aligns with their needs and financial goals while remaining in compliance with IRS regulations. Prior to making any elections it may be appropriate to seek assistance from a qualified tax or legal advisor to ensure you’re making choices aligned with your unique circumstances.

Non-Qualified Stretch: A Closer Look

When a beneficiary elects the stretch option and begins taking Required Minimum Distributions within one year of the original owner’s death, those distributions must be made annually based on the beneficiary’s life expectancy. Life expectancy is determined by using the IRS Single Life Expectancy Table.⁵

How to use the IRS Life Expectancy Table
The initial contract value is determined on the day of the first payment. However, the value of all subsequent payments is based on the year-end (typically December 31) value from the previous year. See the hypothetical below.

Annuity Death Benefit: $250,000
Beneficiary Age: 55
Beneficiary Life Expectancy (IRS Table I): 31.6
$250,000 / 31.6 = $7,911.40⁹

For non-spouse beneficiaries, each subsequent year the life expectancy factor will be reduced by 1 and the distributions will be calculated based on the 12/31 contract value. So, in this example, next year’s life expectancy factor will be 30.6. For a spouse beneficiary, the life expectancy factor is recalculated each year.

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