Annuities are a type of insurance policy. You pay a premium, and in return, your money grows tax-deferred, meaning you don't pay any taxes on the interest the annuity funds earn until you withdraw the money. Depending on whether the annuity is paying out an income, and on what terms, your annuity can be inherited by designated beneficiaries after your death.
Deferred annuities have an accumulation phase and a payout phase. You pay a premium, either one time or on an ongoing basis, and the premium you've paid in grows based on interest, mutual funds or an equity index, depending on the type of annuity. This is the accumulation phase. Whenever you're ready, you can request the annuity be annuitized, which ends the accumulation phase and starts the payout phase. Annuitization means the annuity is being paid out as a guaranteed income for life or a set time period. Immediate annuities skip the accumulation phase -- you pay a premium, and it's immediately turned into income.
All annuities have designated beneficiaries. Typically it's one or more people, but it could also be a trust. If the owner of the annuity dies during the accumulation phase, the balance of the annuity transfers to the beneficiary. If the owner of the annuity dies during the payout phase, the inheritance varies depending on the type of income the annuitant was receiving. If the annuitant opted for payments for the rest of his life, then there isn't any inheritance. The annuity ends at his death. If the annuitant opted for a set period of time, called period certain, it depends on whether there was any time left in the period. For example, if the annuitant decided to take payments over 20 years and died after 10, the beneficiaries would receive the remaining 10 years of payments.
If you inherit an annuity, you are responsible for paying taxes on the inheritance. You will be taxed on the growth of the annuity. If the owner of the annuity started it with $50,000 and the value is now $100,000, you're responsible for taxes on the difference. The taxes are due as you withdraw the annuity inheritance, and you can take up to five years to withdraw the money unless you annuitize the funds. In that case, the payments, and the tax burden, are spread over your lifetime.
If the main purpose of taking out an annuity is to use it for estate planning, consider a life insurance policy as well. There are single-premium life insurance policies, and the proceeds are paid to beneficiaries, in most cases income-tax free. An accountant, attorney or other trusted adviser can help you choose the best option for your individual situation.
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