Many people see annuities as just another investment, but they're actually insurance products that have distinctive characteristics. In particular, most annuities have a death benefit, and understanding how that death benefit will get taxed to the beneficiary who receives it is an important part of deciding whether annuities are right for you.

Spouse vs. non-spouse
As with tax-favored retirement accounts, surviving spouses have an option with respect to annuity death benefits that non-spouse beneficiaries don't have. A surviving spouse can typically choose to take the annuity contract and change it into the spouse's own name. If the surviving spouse does so, there are no immediate tax consequences, and the contract then follows the rules as if the surviving spouse had owned the annuity from its inception.

The other alternatives are available both to spouse and non-spouse beneficiaries. The simplest is to elect an immediate lump sum. However, the downside of doing so is that for an annuity held outside an IRA, the entire amount of the appreciation between what the original owner paid for the annuity and the death benefit will be taxed at ordinary income tax rates. Unlike some investments, annuities do not receive a stepped-up basis at death, and so the tax consequences can be severe.

One way to spread out the tax impact of an annuity death benefit is to take withdrawals over a five-year period. In that case, only the taxable income attributable to the amount withdrawn in any given year will be subject to tax in that year. Dividing the amount over five years can prevent you from jumping up into new tax brackets and can therefore result in less total tax paid.

Finally, the beneficiary can choose to have death benefit payments made over a period not longer than the beneficiary's life expectancy. This can often be the tax-friendliest way to take distributions, although it also results in the beneficiary having to wait the longest in order to receive annuity proceeds.

The key for any beneficiary is to understand that decisions about a death benefit need to be made relatively quickly, and some of them can't be changed once you make the initial decision. Being mindful of the consequences is essential in order to make the best choice for your situation.

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