Many clients own deferred annuities they no longer need for retirement income and simply plan to leave them to the kids. Annuities are excellent accumulation tools, but they are an inefficient way to transfer wealth. Annuity maximization repositions that money into a tax-free life insurance death benefit.
Key takeaways
- Heirs pay ordinary income tax on the gain in an inherited deferred annuity, and larger estates may also owe estate tax on its value.
- Annuity maximization converts the deferred annuity to income, then uses that income to pay premiums on life insurance, often owned by an ILIT.
- The strategy fits clients who are insurable and do not need the annuity for their own retirement income.
A deferred annuity is a great way to accumulate for retirement but an inefficient way to pass wealth to the next generation.
The problem with leaving a deferred annuity to heirs
At death, the gain in a deferred annuity is income in respect of a decedent. Beneficiaries pay ordinary income tax on it at their own rates, with no step-up in basis. For clients whose estates exceed the federal exemption, the annuity’s value can also be subject to estate tax at 40%. Our article on the $15 million estate tax exemption explains who is still exposed.
How annuity maximization works
- The deferred annuity is exchanged or annuitized into a single premium immediate annuity (SPIA) that pays income over a chosen period.
- The client uses the after-tax income to pay premiums on a life insurance policy, or gifts it to an irrevocable life insurance trust (ILIT) that owns the policy.
- The policy is sized to replace or exceed the annuity’s value.
- At death, heirs receive an income-tax-free death benefit instead of a taxable annuity.
Who is a good candidate
- Clients who do not expect to need the annuity for income
- Clients who are insurable at reasonable rates
- Those who want a larger, more predictable legacy
- Clients comfortable using annual exclusion gifts to fund an ILIT
Clients who want to keep more control might pair this with a grantor trust design. Their attorney should confirm the right structure.
Points to review before recommending it
- Surrender charges on the existing annuity
- The tax cost of the SPIA income, which includes a portion of gain
- Any living benefit or death benefit riders being given up
- Underwriting results, which should be known before the annuity is changed
Our case design team can run side-by-side comparisons of keeping the annuity versus repositioning it.
Frequently asked questions
How are inherited non-qualified annuities taxed?
The gain above the owner’s cost basis is taxed as ordinary income to the beneficiary. There is no step-up in basis at death, unlike many other assets.
Does the client need to use an ILIT?
Not always. For estates well below the federal exemption, the client may own the policy directly. An ILIT is useful when estate tax exposure or control over distributions is a concern.
Should the annuity be changed before the life policy is issued?
No. Complete underwriting and have the life policy approved first so the client is never left with the tax cost of the change and no coverage.
Reviewed by Tim Fuller on 2026-09-26
Tim Fuller
President, SRS Inc.
Tim leads SRS Inc., a full-service IMO (Independent Marketing Organization) and BGA (Brokerage General Agency), connecting independent financial professionals with life, annuity, disability income, and long-term care solutions from 60+ carrier partners.
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