If you have an active life insurance policy when you die, the life insurance company pays a death benefit toyour beneficiaries. How the death benefit gets paid is usually up to the beneficiaries. Most people choose a lump-sum payment — 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 payments, and any unpaid amount grows at a fixed interest rate.
Life insurance beneficiaries can choose an annuity to receive multiple payments over a set period (often 10 to 20 years or their lifetime) instead of a lump sum.
Annuities come with tax implications and lower rates of return than other investments.
Most people should choose a lump-sum payout, which is tax-free.
You may choose an annuity if you don’t need the life insurance proceeds to cover existing expenses.
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.
That money 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.
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.
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 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.
Most people choose a lump-sum life insurance payout because it comes with no taxes and they need the financial support. 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, 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 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.
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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.
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 low rate of return, most people will get more value from investing some or all of a lump-sum payout on their own.
There are taxes and fees. Many annuities come with fees that other investment accounts don’t have, which will reduce your returns. Any interest earned on the annuities is also taxable.
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 an annuity long-term.
Instead of a lump sum, beneficiaries of a life insurance policy choose to receive the death benefit in increments over several years. The remaining funds earn interest at a fixed rate.
Most people are better off with a lump-sum payout because they need the money for existing expenses and it is paid out tax-free.
Annuities are not the best investment for most people. You’ll get a greater rate of return from traditional investing accounts that come with fewer fees and penalties.
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.