• An annuity is a type of investment where investors are able to defer taxes on the growth of assets, though never as a capital gain. The tax advantages of annuities are not indefinite; eventually either the investor or the beneficiaries must pay the taxes on the growth of the annuity.
  
  

Contributions

• There are two common types of annuities that investors may be contributing to: qualified or non-qualified. The most common type of qualified annuity is a tax-sheltered 403b annuity offered by tax-exempt employers. Employees make elective salary reductions, which means all the money in the annuity is taxable as ordinary income upon distribution. Other qualified annuities are IRAs, 401k and 457 plans. Non-qualified annuities are supplemental retirement savings accounts where after-tax dollars are contributed so only the earnings are taxed as ordinary income upon distribution.
  
  

Early Distribution

• Most early distributions of annuities are considered withdrawals taken out prior to age 59 1/2. If the annuity owner takes money out prior to this age, there is a high probability that the withdrawal will be taxed and penalized an additional 10 percent. Those in employer-sponsored qualified annuities can start non-penalized distributions at age 55 if employment was maintained until at least age 50. There are IRS approved exceptions from the penalty for certain early distributions. These exceptions include using $10,000 for buying a first home, college tuition or preventing a foreclosure.
  
  

Beneficiary Income

• Annuities avoid probate with one or more beneficiary designated by the annuity owner. After death, a surviving spouse can continue the annuity as if it were their own. Non-spouse beneficiaries must take the annuity and add the amount to ordinary income. The IRS does allow a beneficiary to "stretch" the annuity under certain circumstances. One of the options is to take annuity payments over five years to spread the income tax over time. If the annuity is qualified, the beneficiary has an additional alternative which is to establish a "beneficiary IRA" that takes income spread over the lifetime of the beneficiary.
  
  

Estate Taxes

• Aside from adding the annuity to ordinary income, the annuity is counted in the entire taxable estate. This means that while the annuity avoids the probate process and beneficiaries get direct access to the money, the assets are added to the entire estate value. The entire annuity is subject to state and federal estate transfer tax. Beneficiaries should consult a tax adviser about the best way to liquidate and pay estate taxes to reduce the overall taxability of the estate.