A life insurance annuity is one of the ways the beneficiaries of a life insurance policy can elect to receive the payout — called the death benefit — when the policyholder dies.
You can’t purchase a life insurance annuity on its own — you’ll only have this option if you’re the beneficiary of a loved one’s life insurance policy and they pass away.
How do life insurance annuities work?
After filing a death claim, the beneficiary of the life insurance policy will get to decide how the death benefit is paid out. Most people choose a lump-sum payment. This means they’ll get the entire amount at once, tax-free.
The beneficiary can also choose to receive the death benefit as an annuity. An annuity works like an income steam: The life insurance company pays the death benefit in increments over a number of years.
If your beneficiary opts for an annuity payout, they’ll decide over how many years they’d like to receive those payments. Any funds that remain in the annuity — in other words, the rest of the death benefit — will earn a fixed rate of interest determined by the insurer.
What’s the difference between life annuities vs. life insurance annuities?
A life insurance annuity is different from a life annuity — though they sound similar.
Life annuities are standalone investment products that supplement your retirement income.
You pay premiums or a lump sum to fund the annuity, which gains interest at a fixed or variable rate. You receive payouts from a life annuity until you die.
A life insurance annuity, on the other hand, is only available to beneficiaries of a life insurance policy who are receiving a death benefit.
Life insurance annuities pay out the death benefit to the beneficiaries in increments over a set period of time.
Comparing a life annuity vs. life insurance annuity
Life annuity | Life insurance annuity | |
What is it? | Financial product used to supplement retirement | Payout option for a life insurance beneficiary |
Who funds it? | The annuitant (the person set to receive the annuity payouts) | The life insurance policyholder pays for the insurance coverage that guarantees a death benefit |
Who gets paid? | The annuitant | The beneficiary of the policy |
When does it pay out? | On a set schedule until the annuitant dies | On a set schedule — for a certain number of years or until death of the beneficiary |
Is an annuity a type of life insurance policy?
Annuities are not the same as life insurance policies.
An annuity is a financial product that pays out a sum of money to an individual. Usually, a large amount of money is paid out in regular installments over time.
People can invest in annuities over time to guarantee an income stream later in life.
Some annuities can also be funded with a lump sum instead of regular contributions.
While it’s common for people to arrange for a life insurance death benefit to be paid out as an annuity, annuities are not limited to life insurance. Many people arrange for an inheritance or retirement funds to be paid out in annuities, too.
How long should a life insurance annuity last?
There are two types of life insurance annuities based on how long the beneficiary agrees to receive annuity payments:
Fixed-period annuities
Fixed period annuities are sometimes called specific income or period certain annuities because they last for a predetermined amount of time — usually 10, 15, or 20 years.
If the annuitant — the person who receives the annuity payouts — dies before the period ends, the remaining payments will go to a designated beneficiary.
Lifetime annuities
Lifetime annuities are also known as life income annuities. The beneficiary of the life insurance policy — who becomes the annuitant — receives payments for the rest of their lives.
To avoid the risk of dying early and losing money in the annuity, many people who get lifetime annuities will have a guaranteed period. If the annuitant dies during the guaranteed period, payments will continue to a beneficiary of their own.
Should life insurance beneficiaries choose the annuity option?
Most people choose a lump-sum life insurance payout because it comes with no taxes and offers immediate financial support. But a beneficiary may consider choosing an annuity in the following scenarios.
They have fewer expenses. If they don’t need the death benefit to cover debts or end-of-life expenses the deceased left behind, they might prefer incremental payments.
A lump sum feels overwhelming. If they’re anxious about managing a large life insurance payout, annuity payments may alleviate those concerns.
They want to diversify investments. Annuities earn less interest than traditional investments, but the interest remains stable even in market downturns.
If you’re the beneficiary of a life insurance policy, speak with a certified financial planner who can help you determine whether you’d benefit from converting your life insurance benefit into an annuity.
Pros and cons of life insurance annuities
An annuity can be a helpful tool for anyone deciding how to best manage a large sum of money. Like most financial tools, there are pros and cons to using annuities.
Advantages of life insurance annuities
There are several reasons why someone could consider setting up an annuity.
It’s an easier way to manage a large sum of money. If you receive a large amount of money at once, it can be overwhelming to manage. An annuity will allow you to receive the money incrementally in a way that fits your financial needs.
It gives you a consistent income stream. With an annuity, you can set up regular payments for a period of time or the rest of your life.
You can provide financial support for a loved one. Most annuities will allow you to leave money to a beneficiary when you die. Meaning that if you’re not alive to use the money, it can go to a loved one.
Annuities are tax-deferred. You won’t pay taxes on the money while it’s in the annuity. You’ll only pay taxes on the money when you withdraw it, like a 401(k) or traditional IRA.
Disadvantages of life insurance annuities
There are some risks to choosing an annuity over a lump-sum death benefit.
It takes years to receive the full payout. If the death benefit is worth $1 million, and you select an annuity that pays out $60,000 per year, you’d have to wait almost 17 years to get the full payout.
You could face early withdrawal fees. Unlike traditional investments that let you make withdrawals from your principal, if you want to withdraw additional funds from an annuity on top of your annual payout, you’ll pay high early withdrawal fees.
It’s not the best investment. Because annuities have a low rate of return, most people will get more value from investing some or all of a lump-sum payout on their own.
You’ll pay taxes on interest and additional fees. Any interest earned on the annuities is taxable. Many annuities also come with extra fees and commission costs that other investment accounts don’t have, which will reduce your returns.
When you buy life insurance, the amount of coverage you need should account for all of your beneficiaries’ financial needs: mortgages, childcare, medical care, funeral costs, and any other expenses that might arise with your passing.
Unless your beneficiary can pay off these expenses without assistance, they’re usually better off accepting a lump-sum death benefit to fulfill those immediate needs rather than setting up an annuity. And because the payout is tax-free, a lump sum payout is simpler than managing an annuity long-term.
Frequently asked questions
Should you get a life insurance annuity or a lump-sum payout?
Many people select a lump-sum payout. If you choose an annuity, you’ll pay taxes on interest earned from the death benefit while it remains invested by the insurance company. Lump-sum life insurance payouts are tax-free.
Are life insurance annuities a good investment?
Annuities are not the best investment for everyone. You’ll often get a greater rate of return from traditional investing accounts that come with fewer fees and penalties. A financial professional can help you determine if setting up an annuity with your life insurance proceeds is the best choice for you.
What is the difference between a life insurance annuity and a life annuity?
A life insurance annuity is only available to life insurance beneficiaries receiving the death benefit. Life annuities are separate financial products that earn interest at a fixed or variable rate and pay out over your lifetime.
