What correctly describes the basic tax treatment of deferred annuity death proceeds paid out before the contract is annuitized?

The correct understanding of the tax treatment of deferred annuity death proceeds hinges on how the contract has accrued value over time. When a deferred annuity is established, the premiums paid into the annuity grow on a tax-deferred basis until distributions are made, which includes instances of death benefits.

In the scenario where death occurs before the annuity has been converted into an income stream (annuitized), the proceeds distributed to the beneficiary will include both the return of premium amount and the earnings generated by those premiums. The tax treatment stipulates that the portion of the death benefit that represents the accumulation of premiums is not subject to income tax, while the earnings accrued over the years are taxable as ordinary income.

Thus, if a beneficiary receives a death benefit from a deferred annuity, they will generally owe taxes only on the earnings portion—any gains made on the initial investment—and not on the principal itself. This is why the answer referring to the portions of the contract is not fully encompassing but points to a critical aspect of understanding how tax implications work around such financial products. It is significant for beneficiaries to understand this distinction to anticipate their tax obligations accurately.