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Death Benefits

Most, if not all, annuity contracts have a built in death benefit which pays a lump sum to your beneficiaries in case of death prior to annuitization, similar to life insurance. But buying an annuity for the death benefit is a little like buying a car for the airbags.

Death benefits are rarely cost effective forms of life insurance since a benefit is realized only if the contract cash value is lower than the paid premiums at the time of death. However, in the event of the annuitant’s untimely passing shortly after a significant drop in the contract value, it is possible to leave a significant value to the named beneficiaries.

The most basic death benefit promises to pay at least your original premium amount should you pass prior to annuitizing the contract. For example, an initial investment of $100,000 would typically have a death benefit of $100,000 (minus any withdrawals) or the current cash value, whichever is larger.  Generally a death benefit payout is equal to the higher value between the death benefit or the cash value. The return of principal in the event of death is often touted as an advantage  of annuities relative to other products that may lose value.

In addition to this basic return-of-principal insurance, many contracts offer an enhanced death benefit for an additional fee that could pay some amount greater than the original premium. The following are a few common examples of enhanced death benefits:

Rising Floor or Roll-Up

A rising floor (also called a roll-up) rider increases the minimum death benefit by some specific annual rate, such as 4%, on each anniversary date. Upon death, the payout is usually the greater of the current cash contract value or the premiums paid (minus any withdrawals) increased at the offered interest rate.

Anniversary Step-up or Ratchet

This type of death benefit “Ratchets up” at designated intervals if the cash value is higher than the current death benefit. The step-up establishes a new “floor” for the death benefit going forward so the death benefit at any given time will be equal to the highest anniversary cash value to date. Upon death, the payout is typically the greater of the current cash contract value, the premiums paid (minus any withdrawals), or the highest anniversary value (minus prorated withdrawals).

Enhanced Earnings or Tax Coverage

This type of death benefit is intended to alleviate some of the tax implications associated with annuities. Since one con of annuities is that annuity gains are taxable to your beneficiaries (they do not receive a step-up in cost basis) , the enhanced earnings death benefits add an additional sum to the basic death benefit. For instance, if an annuity purchased for $100,000 has $25,000 in gains at death, the beneficiaries would receive $125,000 plus some “enhanced” amount to help cover taxes on the $25,000 gain. Since the additional benefit amount is calculated on earnings, beneficiaries of a contract that has lost value as of the time of death would not realize any additional value above the basic death benefit payout (for example if annuitant dies during years 4 or 5 in the illustration below).

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