Annuities are often sold as a path to financial security in retirement, but many people skip one important question: what happens to the money when you die? That depends on the type of annuity, the contract terms, and the options available for beneficiaries.

Your Heirs May Not Receive the Remaining Money

With certain lifetime income annuities, payments cease upon the death of the owner/annuitant. If the contract provides income for life only, the insurer generally takes the residual amount (if any), even if the investor has received less than their original investment. Some contracts are specifically designed to provide greater certainty to beneficiaries.

Some contracts provide joint life payments, guaranteed periods, or a refund to the beneficiary. They usually do this at the expense of retirement income.

Death Benefits Can Be Complicated

Many deferred annuities have a death benefit which will allow the beneficiaries to receive either the remaining account value or some other amount as defined in the contract.

Enhanced death benefits usually come with additional fees, and the amount beneficiaries receive may differ greatly from the advertised income benefit base of the annuity.

A guaranteed income benefit of $750k for instance doesn’t necessarily mean the heirs will get $750k.

Inherited Annuities Can Create Tax Problems

One major drawback of non-qualified annuities is their treatment at death.

Unlike many stocks, ETFs, and other investments in taxable brokerage accounts, annuities generally do not get a step-up in cost basis upon inheritance.

Beneficiaries normally pay ordinary income tax on the accumulated earnings of the annuity when distributed. Depending on the contract and beneficiary relationship, distributions may be required within a certain period.

A Diversified Portfolio Offers Greater Flexibility

With a traditional investment portfolio, remaining assets generally pass to beneficiaries or via the estate. Eligible investments in taxable accounts usually receive a step-up in cost basis at death, which in most cases eliminates income tax on appreciation during the original owner’s lifetime.

A diversified portfolio also lets the investor maintain control of their assets without the beneficiary restrictions often found in certain annuity contracts.

The Bottom Line

Annuities can be a great source of lifetime income, but that security may come at the cost of leaving nothing for your family. Depending on the contract, your beneficiaries may receive the remaining account value, a reduced benefit, or nothing at all. For some investors, the trade-off is acceptable with the right contract features.

Before you buy an annuity, you need to know precisely who will control your money after your death, what your beneficiaries will get, and how it will be taxed.

For the investor who is looking for retirement income and at the same time wants to preserve the wealth for the benefit of future generations, a diversified investment portfolio may be the way to go in terms of flexibility and potentially better estate planning outcomes.