What is a life insurance annuity?

If you have an active life insurance policy when you die, the life insurance company pays out a death benefit to your beneficiaries. How the death benefit gets disbursed is usually up to the beneficiaries. Most people choose a lump-sum disbursement—they get the entire amount at once, tax-free, divided between the different beneficiaries.

Another option is to receive the death benefit as an annuity. An annuity works like an income stream: the life insurance provider pays the death benefit in increments over a number of years. You decide over how many years you receive those incremental payments, and the remaining funds earn a fixed amount of interest (which may be taxed).

How do life insurance annuities work?

Annuities are investment products that pay out some amount of money to the annuity owner (or annuitant) over several years. You’re guaranteed at least a certain amount of money every year until the annuity expires or you die.

When a beneficiary chooses to receive the death benefit as an annuity, they work with the life insurance provider to convert their payout into an annuity, a process called annuitization. 

That lump sum is then distributed to them over an agreed-upon number of years. Any funds that remain in the annuity earn a fixed rate of interest determined by the provider.

How long should a life insurance annuity last?

There are two types of life insurance annuities based on how long you agree to receive annuity payments:

• Fixed-period annuities: Also called specific income or period certain annuities, these only pay out for 10, 15, or 20 years. If you die before the period ends, the remaining payments go to a designated beneficiary.

• Lifetime annuities: Also known as a life income annuity. The beneficiary receives payments until they die.

Younger people will benefit most from lifetime annuities since the longer payment timeline may allow for greater interest gains. Older people may prefer a fixed-period annuity, so they don’t risk passing away before receiving the full amount they’re owed.

Life insurance annuity vs. life annuity

You may have been offered the option to purchase a life annuity in the past. Though the two terms are similar, this product differs from a life insurance annuity. 

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’ll receive payouts from a life annuity until you die. 

A life insurance annuity is only available to beneficiaries of a life insurance policy who are receiving a death benefit. 

Who should get a life insurance annuity?

Most people choose to receive a lump-sum life insurance payout because it comes with no taxes and you’ll rarely benefit more from choosing an annuity. But you may consider choosing an annuity if:

• You have fewer expenses: If you don’t need the death benefit to cover debts or end-of-life expenses the deceased left behind—as may be the case for older or retired beneficiaries—then you might prefer incremental payments.

• A lump sum feels overwhelming: If you’re anxious about managing a large life insurance payout, annuity payments may alleviate those concerns.

• You want to diversify investments: Annuities earn a lower rate of return than traditional investments, but the interest remains stable even in market downturns.

Since life insurance is meant to provide for your loved ones when you die, most beneficiaries need at least some part of the death benefit immediately and won’t benefit from leaving most of their payout in an annuity. 

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.

Disadvantages of life insurance annuities

There are some risks to choosing an annuity over a lump-sum death benefit:

• It takes a while to get it all: 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. If you’re older, you risk dying before the entire amount is paid out.

• It’s expensive to withdraw the money: 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 lower rate of return than regular investment vehicles, most people will get more value from investing some or all of a lump-sum payout on their own.

• Taxes and fees: Many annuities come with fees that other investment vehicles don’t have, which will reduce your returns. Any interest earned on the annuities is also taxable.

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 more.

Unless you can pay off these expenses without assistance, you’re almost certainly better off accepting a lump-sum death benefit to fulfill your immediate needs. Because the payout is tax-free, it’s simpler than managing the tax implications of an annuity long-term.