A beneficiary receives a lump-sum death benefit from a deferred annuity. Which portion is taxable as ordinary income?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
Annuity death benefits are taxed differently from life insurance proceeds. The beneficiary receives the accumulated value, but only the earnings portion, the amount exceeding the owner's cost basis, is taxable as ordinary income; the return of principal is received tax-free. This contrasts sharply with life insurance, whose death benefit is generally income-tax-free under IRC Section 101. Because the growth inside an annuity has not been taxed during accumulation, the gain is recognized when it is distributed to the beneficiary, so the taxable amount is exactly the growth over the original investment.
Why the other options are wrong
- B) The entire payment is not taxed; the basis, the owner's original investment, comes back tax-free. Only the gain accumulated inside the contract is recognized as ordinary income at distribution.
- C) The basis is the tax-free portion, not the taxable one. Taxing the basis would amount to double taxation of money that was already paid with after-tax dollars.
- D) Annuity death benefits do not enjoy the same income-tax exclusion as life insurance proceeds under IRC Section 101. The gain inside the annuity is taxed as ordinary income when it is distributed to the beneficiary.
Memory hook
Annuity death payout: gain taxed, basis free. Life death payout: all free. Different worlds.