An annuitant paid $40,000 into an annuity contract and died before any payout began. The contract pays its $55,000 death benefit to the named beneficiary in a lump sum. How much of that payment must the beneficiary include in gross income for federal income tax purposes?

Why A is correct

Unpaid annuity death benefits are taxed under the annuity rules of IRC Section 72: the portion representing the owner's investment in the contract ($40,000) is a tax-free return of capital, and only the $15,000 of gain above basis is included in the beneficiary's gross income as ordinary income. Annuity death benefits do not receive the IRC Section 101 exclusion that applies to life insurance death proceeds, which is the distinction the exam objectives specifically emphasize.

Why the other options are wrong

• B) Annuity death benefits do not receive the IRC Section 101 exclusion that applies to life insurance death proceeds; only the $40,000 basis is recovered tax-free, so the taxable amount is not zero.
• C) The $40,000 investment in the contract is a tax-free return of capital, so the entire $55,000 is not included in income.
• D) This reverses the rule: the investment in the contract is the tax-free portion, and the $15,000 gain above it is the taxable portion.

Memory hook

Death benefit gets the Section 101 pass; annuity leftovers are taxed under Section 72.