Per stirpes vs. pro rata: non-qualified annuity beneficiaries

When you name beneficiaries on a non-qualified annuity, one instruction decides what happens if a beneficiary dies before you do: per stirpes or pro rata. The wording looks minor on the form. It can change who receives the money, how much of it, and who owes the income tax on the gain.

Per stirpes means “by the branch.” If a beneficiary dies first, that person’s share passes down to their descendants. Pro rata means “in proportion.” If a beneficiary dies first, that share is divided among the surviving beneficiaries in proportion to their stated shares.

What a non-qualified annuity is

A non-qualified annuity is one you buy with after-tax money. Those dollars are not sitting inside an IRA, a 401(k), or another tax-qualified retirement plan. You have already paid income tax on what you put in. That amount is your cost basis. Only the growth above that basis is taxed as ordinary income when it is paid out.

• Tax-deferred growth. Interest is not taxed each year while it stays in the contract.
• Death benefit. At the owner’s death, the contract generally pays the named beneficiaries directly, outside of probate.
• No required withdrawals during life. Unlike a traditional IRA, a non-qualified annuity does not require annual distributions at a set age.

Per stirpes, in plain English

Picture your family tree. Each of your children starts a branch, and each branch receives its share. If one of your children has died, that child’s share does not disappear, and it is not handed to your other children. It flows down that branch to the child’s own descendants, who divide it among themselves.

• Each family line keeps the share you planned for it.
• A grandchild is not cut out because their parent died first.
• If a grandchild has also died, that share can continue down to their own children.

Pro rata, in plain English

“Pro rata” means “in proportion.” Unlike per stirpes, it is not a formal inheritance-law term, so how it works depends on the form and the carrier. On beneficiary designations it commonly means that if a named beneficiary does not survive you, the remaining beneficiaries receive that share in proportion to their own percentages. The share stays with the survivors rather than passing to the deceased beneficiary’s family.

• Simpler and faster. The insurer divides the money among the people still living.
• It honors your ratios. If you chose 50/30/20, the survivors keep their relative weight.
• It can leave a branch out. If a child dies first, that child’s own children receive nothing from this annuity unless you named them separately.

Many carrier forms offer “per stirpes” and “per capita” as the standard choices, and some annuity carriers treat survivors-only wording as the default. Read the carrier’s exact definition on the form, and ask your attorney to confirm that it matches what you mean.

Example: equal shares

This is a hypothetical, not a quote. A non-qualified annuity is worth $600,000, with a cost basis of $400,000, so $200,000 of the value is taxable gain. Three children, Anna, Ben, and Chris, are named as equal beneficiaries. Ben dies first, leaving two children, Bella and Brooks. The gain is one-third of the value, so about one-third of each payout is taxable.

Under per stirpes, Ben’s one-third share ($200,000) passes to his two children, and the taxable gain is spread across four people. Under pro rata, Anna and Chris each receive an extra $100,000 and report an extra $33,333 of gain, while Ben’s children receive nothing from this annuity.

Example: unequal percentages

Same annuity. This time Anna is named for 50%, Ben for 30%, and Chris for 20%. Ben again dies first, leaving Bella and Brooks.

With pro rata, Anna and Chris share the whole account in a 50-to-20 ratio, which is about 71.4% and 28.6%. Ben’s 30% is absorbed by the survivors. With per stirpes, Ben’s 30% stays on his branch.

Side by side

What happens at death

• The insurer is notified. A beneficiary or the estate contacts the carrier and provides a certified death certificate and the carrier’s claim forms.
• Each beneficiary chooses a payout. Each beneficiary generally elects how to receive their own share, within the time limits that apply.
• Gain is taxed as ordinary income. The beneficiary reports the gain above the owner’s cost basis. The insurer typically reports it on Form 1099-R.

How a beneficiary can take the money

Under federal tax rules, when the owner of a non-qualified annuity dies, a non-spouse beneficiary generally must take the money in one of two ways.

• The five-year rule. Take the full value, as a lump sum or in withdrawals, within five years of the owner’s death.
• Lifetime or life-expectancy payments. Receive payments over the beneficiary’s own life expectancy, with the first payment starting within one year of the owner’s death. This can spread the taxable gain over many years.

A surviving spouse who is the sole beneficiary can usually continue the contract as the new owner, which keeps tax deferral going. If the estate is the beneficiary, or no beneficiary survives, the five-year rule commonly applies and the money may pass through probate.

How the tax on the gain works

• Ordinary income. Gain is taxed at the beneficiary’s own income tax rates, not at capital gains rates.
• Cost basis comes back tax-free. The portion of the payout that returns the owner’s after-tax premium is not taxed again.
• No basis step-up. Unlike stocks or real estate, annuity gain does not get a new cost basis at death.
• Spreading the gain matters. Per stirpes divides gain among more people, which can mean lower brackets. Pro rata can concentrate it in fewer, possibly higher, brackets. Gain paid to minors may be subject to special tax rules.
• Different from IRAs. Inherited IRAs and other qualified accounts follow separate distribution rules.

When each approach tends to fit

Per stirpes may fit if you want every child’s family line treated equally, you have grandchildren you want to provide for, your family has blended or multiple marriages, or the legacy is meant to continue by generation.

Pro rata may fit if you want a simple split among named people, you prefer the survivors to share what is left, your beneficiaries are friends, charities, or a small group, or you have already named contingent beneficiaries separately.

Mistakes I see on the form

• Leaving the box blank. The default may not match what you want, and it differs by carrier.
• Never naming contingent beneficiaries. If every primary beneficiary has died, the annuity may go to your estate and through probate.
• Not updating after life events. Marriage, divorce, births, and deaths all change the picture.
• Assuming your will controls. Beneficiary designations on annuities generally take priority over a will.
• Ignoring minors. Young beneficiaries cannot generally receive large sums directly. A trust or custodial account may be needed.

Questions worth answering before you sign

• Who should receive the money if a beneficiary dies before you? Their children, or the other beneficiaries?
• Does this carrier’s form define per stirpes and pro rata the way you expect? Ask for the definition in writing.
• Are contingent beneficiaries named? Include a backup for every primary.
• Do any beneficiaries need a trust? Minors and beneficiaries with special needs often do.
• When did you last review every designation? Every annuity and policy needs its own review.

Review every beneficiary designation after a marriage, divorce, birth, or death, and at least every few years. A short review is the easiest way to keep what you intend and what the paperwork says in the same place.

A few questions people ask

Can you name a trust as the beneficiary instead? Yes. Many families name a trust so a trustee manages the money for minors, heirs with special needs, or someone who may not manage a large sum well. Payout and tax rules for trusts can be complex. That is a job for an estate planning attorney.

What if you never choose either option? The carrier applies its default. Defaults differ by company and by product, which is why it is worth asking and writing the answer down.

Can each beneficiary choose a different payout? Generally, yes. Each beneficiary of a split annuity can usually elect their own payout option for their share, subject to the carrier’s rules and the federal time limits.

The words, in short

A beneficiary form is a few checkboxes. The decisions behind it will shape your family’s finances for a generation.

If you would like to review how your annuities are designated, that conversation is complimentary and carries no obligation. You can start that conversation with Ted.

This is education, not legal, tax, investment, or insurance advice, and not a quote or an offer. Ted Byrer is a licensed insurance professional, not an attorney and not a tax advisor. This article addresses non-qualified annuities only. IRAs and other qualified accounts follow different rules. Beneficiary forms, the definitions of per stirpes and pro rata, default rules, payout options, and tax treatment vary by carrier, contract, and state and can change. The examples are hypothetical and simplified. Talk with your estate planning attorney and tax professional about your situation. Any guarantees associated with an annuity depend on the claims-paying ability of the issuing insurance company. Annuities are not a deposit, are not insured by the FDIC or any government agency, and may lose value.