Annuities are insurance policies that guarantee you an income during your life. However, the insurance policy also pays a death benefit if you do not use the funds prior to your death. This death benefit is paid out to beneficiaries you name, similar to how a death benefit is paid out in life insurance policies. However, unlike life insurance, annuity death benefits are subject to income tax.
A lump sum annuity payment at death means that all of the money in the annuity account is paid out to beneficiaries. This payment amount is fully taxable to the extent that there are gains in the policy. A gain is any amount of money in excess of the total amount of money contributed to the account.
Annuity payments are a second death benefit option. The annuity may be converted to monthly payments. Under this option, the beneficiary of your annuity receives payments for a set number of years or for the life of the beneficiary. These payments consist of mostly a return of principal with a small amount of interest added to the payment amount. This, in turn, reduces the overall tax burden payable in any given year.
The benefit of the taxation of annuity death benefits is that your beneficiary has a choice as to how taxes are paid. With most investments, there is little choice as to when you pay taxes. With annuities, your beneficiaries can choose which option best serves their interests.
Consider purchasing an annuity inside of a Roth IRA. Roth IRAs are tax-free retirement accounts. However, an annuity inside of a Roth IRA inherits the tax benefits of the Roth. So, your beneficiaries get the benefits of the insurance policy (choice of how to receive the death benefits), but they also receive the death benefit tax-free since the Roth account is tax-free.