Annuities are investment products that are offered by insurance companies. There are a number of different types of annuities that serve unique estate planning purposes, though most annuities are designed to accomplish two core functions—to provide an income stream during your lifetime, and to transfer assets to a beneficiary when you die.
Regardless of what type of annuity you own, the death benefit paid to the designated beneficiary is not subject to probate. When you die, the insurance company will transfer the assets to your beneficiary as soon as they receive a certified death certificate with the required paperwork.
How Does an Annuity Bypass Probate?
Assets that have a designated beneficiary listed on the account are allowed to transfer ownership outside of probate. Such assets (referred to as non-probate assets) include:
- Life insurance policies and annuities
- Bank and brokerage accounts with a payable-on-death or transfer-on-death beneficiary
- Retirement accounts (IRA, 401k, etc.)
- Real estate owned as joint tenants or as tenants in the entirety
It’s a common misconception that annuities are only allowed to bypass probate because they’re offered by life insurance companies. In reality, the deciding factor is the ability to register a designated beneficiary with the annuity provider. The fact that the assets are transferred as a death benefit by an insurance company does offer some unique tax benefits, but that’s a separate conversation you’ll need to have with your financial advisor.
Designating a Beneficiary
As the designated beneficiary is the key to how an annuity bypasses probate, it’s crucial to properly choose and register your intended beneficiary. You can designate any individual or organization as the beneficiary, but the beneficiary must be alive at the time of your death in order for the death benefit to bypass probate. Additionally, you can’t list yourself or your estate as the beneficiary if you want the death benefit to skip probate.
Most annuity providers allow you to designate multiple primary beneficiaries, and the death benefit doesn’t need to be split equally among the recipients (e.g. you could allocate 75% to one beneficiary and 25% to another beneficiary). If your annuity provider lets you designate contingent beneficiaries, it’s a good idea to take advantage of this designation, too. Contingent beneficiaries will receive the death benefit only if the primary beneficiary predeceases you, so they’re a helpful way to make sure the death benefit doesn’t end up in probate if the primary beneficiary dies at or before the date of your death. For example, if your spouse is the primary beneficiary to your annuity, it may be wise to list your children as contingent beneficiaries in case you and your spouse pass away together in an accident.
Distinguishing the Owner From the Annuitant
With annuities, it’s important to understand the difference between the owner and the annuitant, as the death of one may not trigger the death benefit. The owner is the entity who funds the annuity, while the annuitant is the recipient of the annuity’s income payments during the distribution period. The owner is often the same as the annuitant, but when there’s a difference it’s typically the death of the annuitant that triggers the death benefit, not the owner.
How is the Death Benefit Determined?
Some annuities can immediately turn a lump sum investment into an income stream (known as immediate annuities), while others have an accumulation period before the distribution period begins (known as deferred annuities). During the accumulation period the death benefit is typically equal to the total account value, including the principal and accumulated interest. During the distribution period, the death benefit is usually equal to the principal and accumulated interest less the value of any income payments.
If you have an annuity with a guaranteed death benefit, the ultimate value of the death benefit transferred to your beneficiary will depend on the details of your annuity contract and the presence of any riders. For example, some annuities guarantee a minimum death benefit equal to your initial investment value, even if the account value at the time of your death is less due to income distributions. Similarly, some deferred annuities offer guaranteed “step-ups” during the accumulation period that could make the death benefit greater than the cash value at the time of your death. It’s not uncommon to see an annuity that offers a one-time step-up at the time of your initial investment (e.g. a 10% bonus), or an annuity that offers guaranteed annual step-ups (e.g. guaranteed 4% growth each year).
Death Benefit Payment Options
While there are a variety of death benefit payment options with annuities, there are three common choices:
- Lump sum distribution – the beneficiary will receive the death benefit as a single lump sum payment.
- Non-qualified stretch – the beneficiary will receive minimum payments (guaranteed by the annuity company according to the contract) stretched over the beneficiary’s life expectancy.
- Five-year rule – the annuity company will retain ownership of the death benefit for five years, and the beneficiary will have the ability to withdraw portions of the total value at their discretion. At the end of five years, the annuity company will distribute any remaining value to the beneficiary.
Note that when the beneficiary is the annuitant’s spouse, he or she may have the ability to continue receiving lifetime income payments under the original annuity contract. This option is usually available through a joint-income rider. When the joint owner passes away, the death benefit would then be paid to the contingent beneficiary.
How to Transfer Non-Probate Assets
Whether the asset in question is an annuity, bank account, retirement account, or real estate, the process of transferring non-probate assets is generally the same:
- Obtain a certified copy of the death certificate – to get a certified copy of a death certificate, you’ll need to contact the state or county vital records office. There’s usually a printing fee in the ballpark of $5 per copy.
- Fill out the required forms – the financial institution with custody of the asset in question should have a set of forms to initiate the transfer. The financial institution won’t be able to provide you with the owner or annuitant’s private information due to privacy laws, but you can gather account numbers and related information from recent account statements.
- Have the signatures notarized – most transfer forms require notarized signatures. The signing party (or parties) will need to sign in the presence of a notary public, who will then stamp and sign the form.
- Submit the required paperwork – since you’re providing a certified copy of the death certificate, you’ll need to mail the paperwork to the financial institution rather than faxing or emailing it.