Annuities✓ Verified · outline & fact-checked · Sep 2026Difficulty 3/5
An owner paid $100,000 into a nonqualified annuity with an installment refund option. After only two years of income payments, the annuitant dies and the beneficiary receives the remaining $70,000 of principal. How is the beneficiary's payment taxed?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
The refund of the owner's investment in the contract — the $70,000 of remaining principal — represents a return of cost basis and is not taxable to the beneficiary. Annuity payments are only taxed on the amount by which they exceed the investment in the contract. Since the refund merely returns remaining principal, no gain is realized, and the beneficiary recognizes no income tax on the refund amount.
Why the other options are wrong
- B) Only the gain over basis is taxable; principal returned under a refund feature is a nontaxable return of capital, so taxing all $70,000 is incorrect.
- C) The tax result depends on basis recovery, not on how quickly the death benefit is received.
- D) Annuity distributions are taxed as ordinary income, not capital gain; and here no gain exists because the payment equals remaining basis.
Memory hook
Refund = giving back the investment in the contract. Return of basis is never taxed.