Ben Franklin's quote about nothing being certain but death and taxes is never more true than with beneficiaries of annuities. The only exception is in the case of a spousal beneficiary who can choose to continue the annuity in her name, contribute to it and receive tax deferral on the accumulations. High bracket annuity beneficiaries must pay ordinary income tax on all accumulations in excess of aggregate payments into the contract. There is no capital gains treatment on gain.
Select one of the three Internal Revenue Service (IRS) approved distribution options that will best fit the beneficiary's needs. A heavy bill burden favors a lump sum choice. High tax bracket individuals may select five-year payouts to spread out the tax hit. If the beneficiary's preference is stable income or more stretched out taxation, she can take a life payout that distributes annuity principal and taxable growth over her life expectancy on a monthly or less frequent periodic basis.
Discuss the choice of payout options with the annuitant because the annuitant's selection will determine not only what, if anything, the named beneficiary will receive but over what period taxes payments can be stretched. For example, the owner decides to take a "Life Only" annuity to receive the highest payout per $1,000 of accumulated savings, then he dies soon after. Insurance companies don't permit a beneficiary designation on this annuity payout option. All other lifetime annuity payouts do allow a beneficiary designation for the balance of the annuity fund not yet paid to the annuitant before his death. In those cases, a beneficiary will receive a continuation of the decedent's periodic payments for the balance of the specified payment period. Part of each payment will be taxable income and the rest nontaxable return of principal in the same proportion as the earlier payments to the decedent.
Take the payout option that stretches out the payment of taxes over the greatest number of years possible within the limits of the mandatory distribution rules. Ultimately, tax on gains is unavoidable because U.S. federal tax law requires mandatory distribution of annuity death proceeds to nonspousal beneficiaries. Even spousal beneficiaries who choose to continue a decedents' deferred annuities in their own names are only postponing the inevitable tax bill that they or their beneficiaries will have to pay when the money is finally disbursed.