An annuitant dies before receiving all guaranteed payments under a refund annuity. The unpaid amount is paid to the beneficiary. How is this payment treated for federal income tax purposes?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
Unpaid annuity benefits paid to a beneficiary after the annuitant's death are taxed as annuity payments, not as a tax-free death benefit. Under the annuity exclusion ratio in IRC Section 72, the portion of each payment representing the return of the annuitant's cost basis is recovered tax-free, and the remainder - the growth and earnings - is ordinary income. This contrasts with life insurance, where death proceeds are generally income-tax-free under IRC Section 101. The official examination objectives specifically flag the difference between annuity unpaid benefits and life insurance death benefits.
Why the other options are wrong
- B) Life insurance death proceeds are income-tax-free under IRC Section 101, but annuity death benefits are not. The distinction between the two products is a common exam trap.
- C) The form of payment, lump sum or installment, does not change the tax character of the annuity benefit. The exclusion ratio applies to the payments as they are received.
- D) Only the cost-basis portion is a tax-free return of capital. The earnings and growth portion of the unpaid benefit is taxable as ordinary income.
Memory hook
Annuity leftovers to the beneficiary are taxed; life insurance death benefits are not.