Dear Eric,
An enhanced death benefit in an annuity can cause a beneficiary to pay more in federal income taxes than a standard annuity death benefit, says Jeff Thompson, a tax manager with Jackson National Life Insurance Co. This can happen because an enhanced death benefit can increase the amount of "gain" in the policy.
If an annuity is worth more than you have paid in premiums, any gain in the policy is taxable whether it is paid out in a death benefit or as payments in the annuitization phase of the policy. For example, if you bought a variable annuity for $30,000 and it increased in value to $35,000, the gain of $5,000 would be subject to federal income taxes. If that same policy had an enhanced death benefit that increased the value to $40,000 when it paid out, the beneficiary would have to pay federal income taxes on $10,000.
This is very different from the way life insurance death benefits are taxed, says Thompson. Life insurance death benefits are not subject to federal income taxes, although in some cases they may be subject to federal estate taxes. For more information on how life insurance and annuities are taxed, use the Insure.com Life Insurance & Annuity Tax Tool.
Disclaimer: We are journalists, not financial planners or insurance brokers. Nothing we say should be interpreted as a recommendation to buy or sell any insurance product, or to provide other financial or legal advice.
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