Variable Annuities Aren't Just for Retirement: How Death Benefit Riders Work
(Variable annuities with death benefit riders blend the best of investing with the best of life insurance — here's how)
Maggie Tiede |November 14, 2019
Variable annuities blend the stability of insurance with the gains of investing. In addition to the stable monthly income they provide for your retirement, variable annuities can even provide a guaranteed death benefit to your beneficiaries if you pass away within the term of the policy.
If you’re wondering how variable annuity death benefits work (and why you’d even want them), this guide is for you. When you’re done, expert independent insurance agents are on hand to help you shop for the right variable annuity for you.
What Is a Variable Annuity?
A variable annuity is an investment vehicle that shields your money from lawsuits and excessive taxes. It has two phases: the accumulation phase and the annuitization phase.
In the accumulation phase, you grow your money in mutual funds and other investments kept under the same investing umbrella to minimize your tax exposure.
In the annuitization phase, you take the money you grew in the accumulation phase and convert it into a monthly income (this income is called an annuity). The value stops growing because the money is no longer being invested.
The more successful your accumulation phase is, the more monthly income you will have when you decide to annuitize.
Annuities are closely tied to life insurance. They are typically sold and managed by life insurance and financial planning companies.
Variable Annuities and Death Benefits
A death benefit is a life insurance payout given to your beneficiaries (the people you name in your life insurance policy) if you pass away while the policy is in effect. There are two ways variable annuities can affect death benefits:
A variable annuity policy may pay out a death benefit in addition to annuities just like a life insurance policy
Because variable annuities are part of life insurance, they can get around probate court after your death, meaning your beneficiaries can receive a steady monthly income as fast as possible instead of being tied up in your estate
Guaranteed Death Benefits
Guaranteed death benefits are exactly what they sound like — death benefits you’re guaranteed to get. Some variable annuity policies have guaranteed death benefits, while others may place conditions on when you’ll receive your death benefit.
If you’re looking for a variable annuity that offers a death benefit, you should always ask whether or not it’s guaranteed, and if it does have terms, what they are. An independent insurance agent can help you cut through the jargon and make sure you know exactly what you’re getting.
What Covers the Cost of a Variable Annuity Death Benefit?
With a variable annuity, your own investment dollars typically pay for the death benefit. That’s why variable annuity death benefits sometimes have special terms and conditions: if you’ve already drained the bulk of your account through annuities, there’s no money left for a death benefit.
If your variable annuity has something called a death benefit rider, you may also pay premiums that go towards the death benefit.
What Is a Variable Annuity Death Benefit Rider?
To simplify your life insurance, you may choose to add on a more traditional life insurance policy to your variable annuity. This is called a death benefit rider.
If you choose this option, you’ll have to pay premiums — it’s not a free benefit — but you may get a discount for bundling your insurance and annuity services at the same company.
You may also be able to pay for the death benefit rider through returns on the variable annuity itself, but this can severely limit the growth of your account and should be done carefully.
If you pass away while covered by a death benefit rider, it makes things easier for your beneficiaries if the life insurance and the annuities are all administered through the same company. No one wants to deal with red tape while they’re grieving. A death benefit rider can be a real gift to your loved ones for this reason.
What Is the Best Death Benefit Rider?
The best death benefit rider is the one that meets your unique insurance needs at a cost you can afford. Because everyone has differing budgets and reasons for purchasing life insurance, there isn’t just one “best” option.
Things to look for in a death benefit rider include:
A benefit large enough to meet your needs — for example, large enough to pay for a child’s college expenses, if that’s a reason you’re buying life insurance — but not much larger.
A reasonable cost in premiums. If premiums are paid as a percentage of your variable annuity investments, make sure that the percentage isn’t so large that it eats into your returns.
Discounts. Most insurance companies offer bundling discounts if you buy multiple products from them. A death benefit rider is technically a separate product from a variable annuity, so be sure to ask if you can get a discount for purchasing both.
Death Benefit Riders after Annuitization
Commonly, death benefit riders cover the accumulation phase of a variable annuity and end after annuitization. However, this isn’t always the case. You can add on a death benefit to your variable annuity even after annuitization if it makes financial sense for you.
The details will depend on your specific variable annuity contract. An independent insurance agent can help.
Variable Annuities, IRAs, and Death Benefits
Individual Retirement Accounts (IRAs) are closely linked with variable annuities. They offer similar tax and liability protection and variable annuities are often offered under the umbrella of IRAs. If you have an IRA, you may be able to add a death benefit rider to it.
Roll Up Death Benefits and Ratcheting Death Benefits
A good feature to look for in a variable annuity is a roll up, especially if you want to include a death benefit rider. Roll ups guarantee a certain amount of return even if your investments perform poorly, protecting your future annuities and any death benefits from being eaten up by a bear market.
Roll ups are related to ratcheting, where an insurance contract guarantees that your death benefit will “ratchet” up over time by a certain percentage or dollar amount each year (or other interval outlined in the contract).
Withdrawing from a Variable Annuity: Proportional Reductions and Dollar for Dollar Reductions
You can typically withdraw a small amount (10% or under) from your variable annuity each year without incurring fees. This can impact death benefits significantly because there’s less money in your account to cover a death benefit.
There are two main types of reductions:
Proportional reductions: If you withdraw from your account, proportional reductions reduce the amount in your account by a proportion (or percentage) rather than a dollar amount.
Dollar for dollar reductions: If you withdraw from your account, dollar for dollar reductions reduce the amount by the exact dollar amount you withdrew rather than by a proportion.
Your contract will generally allow only one or the other, not both. Which option is best depends on whether or not the policy has roll ups, ratcheting and/or a guaranteed death benefit.
Generally, proportional reductions are best when the cash value of your death benefit rider exceeds the actual death benefit, which can happen if your investments do very well and outpace the roll ups.
Dollar for dollar reductions are best when the opposite is true — when the minimum death benefit exceeds the cash value of your investments, which can happen if your investments do poorly or if you have high roll ups, ratcheting, or a guaranteed death benefit.
Withdrawals are best done with the help of your independent insurance agent to make sure you’re not accidentally hamstringing your death benefit.
Are Variable Annuity Death Benefits Taxable?
Variable annuities offer significant tax advantage, including their death benefits. According to the IRS, a life insurance death benefit does not have to be reported as taxable income. However, if you earn interest on a death benefit, you must report that.
If you pull money out of a variable annuity before annuitizing it, it’s no longer tax-deferred and you must pay tax, except in the case of a death benefit. After annuitizing it, the monthly income you receive from the annuity is generally treated as income and you may owe some taxes on it (but you won’t need to pay taxes on your entire investment all at once).
The independent insurance agents who sell variable annuities must also have a securities license. They’re financial experts who can help you understand the ins and outs of variable annuity taxes, so don’t hesitate to ask!
Variable Annuities, Death Benefits and Probate Court
One of the biggest benefits of variable annuities is that they go around the probate court system. Instead of getting tied up in your estate, your benefits go straight to your beneficiaries. They are not subject to probate.
If your variable annuity contract includes a death benefit, then your beneficiaries will receive that. You can also designate beneficiaries for the entire variable annuity account, meaning they’ll take over the investment (if it’s in the accumulation phase) or the monthly income (if it’s in the annuitization phase).
This is especially useful if you are supporting children, a spouse, or other dependents. Receiving a variable annuity can provide for them far into the future, even more so than a traditional death benefit can.
How Independent Insurance Agents Can Take Your Financial Planning to the Next Level
Independent insurance agents might not be your first guess for experts who can help you plan for retirement — but they should be. In order to sell annuities, independent insurance agents must have a securities license in addition to their insurance license. That makes them the Swiss Army knife of financial professionals.
Captive insurance agents and financial planners are bound to working for only one company, meaning they can’t shop around to find you the deal you really want. Independent insurance agents have the full picture. They’ll take a look at your unique needs and help craft quotes just for you.
Your financial future is too important to leave in the wrong hands. Shopping with an independent insurance agent is shopping smart.