Types

• There are two types of annuities that you may give to your heirs. A fixed annuity is an annuity that pays a fixed rate of return. The rate of return is based on bonds or bond-like investments. The underlying investments of a variable annuity, on the other hand, are mutual fund sub-accounts. These accounts are not guaranteed to produce any particular return. Instead, the value of the annuity (and thus the death benefit) fluctuate with the value of the mutual funds that the annuity savings is invested in.
  
  

Significance

• Even though both fixed and variable annuities invest in investments, the tax paid on the annuity is not capital gains. Instead, the proceeds are taxed as ordinary income. This is because the IRS treats annuities as a kind of retirement account. The IRS eliminates the tax on the annuity's account value as long as the money remains inside of the annuity. When money is withdrawn, it's considered income.
  
  This carries over to the death benefits of the annuity. Since the annuity's death benefit is the same as its account value, the annuity's death benefit is also taxed at ordinary income tax rates.
  
  

Benefit

• The benefit of annuities is that you control how the tax is paid on the death benefits. With capital gains tax, you sell the investment and pay the tax on the gains you experience. With an annuity, your beneficiaries may take a lump sum payment or convert the entire account to monthly payments. When your beneficiaries convert your savings to monthly payments over their lifetime, most of the payment is considered to be a return of principal with a small amount of interest added to the payment. This effectively reduces the tax your beneficiaries pay when compared to taking a lump sum amount.
  
  

Disadvantage

• The disadvantage to annuities is that, even by converting your savings to an income, your beneficiaries may end up paying more in tax than if they had paid capital gains on your savings. This is because capital gains tax rates are generally lower than ordinary income tax rates (as of 2010).
  
  

Consideration

• If you want to eliminate the tax due on an annuity after your death, consider investing in an annuity inside of a Roth IRA. Roth IRAs eliminate income tax on all investments in the Roth account, but also eliminate the tax due on any withdrawals from the Roth. The annuity inside of a Roth inherits the tax benefits of the Roth. In this respect, you receive a tax-free annuity. If you do invest in an annuity inside of a Roth, however, you give up the unlimited contribution amount that is available outside of the Roth.
  
  Annuities are not limited in regard to how much money may be contributed to the annuity account. Roth IRAs cap annual contributions at $5,000 (if you're under age 50) and $6,000 (if you're 50 or over).
  
  When you die, your annuity will be transferred inside of the Roth IRA. Since the Roth is not taxed on withdrawals, the annuity will be passed to your heirs income tax-free.