What happens to interest earned if the annuitant dies before the payout start date?

• A. It is taxable
• B. It passes tax-free to the beneficiary
• C. It becomes part of the insurer's reserve
• D. It is refunded to the policyowner

Answer: (A)

Interest earned inside an annuity grows tax-deferred, but when money is distributed, that earnings portion is taxed as ordinary income. If the annuitant dies before the payout start date, the death benefit paid to the beneficiary includes the accumulated earnings up to that point, and those earnings are taxable to the beneficiary. The principal may be returned tax-free if it consisted of after-tax contributions, but the gains are not tax-free. This is why the correct understanding is that the interest earned is taxable. The money doesn’t pass tax-free to the beneficiary, doesn’t become the insurer’s reserve, and isn’t simply refunded to the policyowner.