Life insurance annuities: What they are, how they work


As the beneficiary of a life insurance policy, one option is to receive the death benefit as an annuity. But while life insurance and annuities are related products, they work in seemingly opposite ways.

    With whole life insurance, you make set monthly payments to an insurance company for as long as you are alive, in return for a death benefit payment to your beneficiary or beneficiaries when you die. With an annuity, you make a large payment to an insurance company upfront, and in return, you receive set monthly payments for as long as you continue to live. Why consider combining the two? This article will help by providing a high-level overview of the following:

    How life insurance and annuities can complement each other

    There are many different kinds of life insurance. A policy can be temporary or permanent. It may have cash value – or not. But the one defining feature of all life insurance policies is a death benefit. It’s the most important reason to get a policy, and how it is almost always described: when people say they have a $1,000,000 policy, it means that a $1,000,000 benefit will be paid to their beneficiaries upon their death.  

    If you are the beneficiary of a life policy, what you do with your share of that benefit is up to you. Insurance companies typically give beneficiaries the choice of getting their payment in one of three different ways:

    1. A lump-sum payment. This is the most popular option, and the default choice: you get a large amount of cash deposited directly to your bank account, to do with as you please. 
    2. Installment payments. You can also choose to have the benefit amount sent to you in a series of payments over time. The insurer holds the money in an account that can pay interest and sends you a monthly check for whatever amount you choose until the principal runs out. If you decide you need more each month, you just ask the company to increase the amount – but the principal will run out that much sooner. 
    3. An annuity.  The insurance company takes your benefit payout, invests it for the long term on a tax deferred basis, and in return, they provide a monthly stream of income that lasts for the rest of your life.1

    Why some beneficiaries choose annuities

    As we noted in the beginning, life insurance and annuities are closely related: they both rely on actuarial science, the discipline that applies the mathematics of probability and statistics to assess financial risk. A life insurance policy provides protection for the risk of early death by providing an income tax-free death benefit to replace income you would have otherwise earned to care for your family. That's widely understood – but what do annuities help provide protection for? By providing monthly payments that last your entire life, an annuity can help protect you from the risk of longevity – and outliving your savings.

    While it may seem odd to worry about longevity, the problem of outliving one’s assets is a very real issue faced by people approaching or in retirement. So, the promise of lifetime guaranteed income can be attractive to many older beneficiaries, especially if they are in good health. If a beneficiary stays healthy and lives long enough, the combined annuitized payments can be greater than the original life policy payout. But there can be downsides as well: if you are a relatively young widow or widower who needs income to raise a family, the monthly payments may not be enough to replace the monthly earnings a working spouse would have otherwise provided. 

    Life insurance annuities and family trusts

    If you don’t want to leave the choice of getting an annuity up to your beneficiary – for example, because he or she has special needs – you can choose for them by using a trust: a legal entity created for estate planning purposes, and administered by a trustee that you choose. A properly-established trust can hold and distribute assets to your beneficiaries according to the terms you choose when you create the trust.

    Parents who want to provide support for a child who has a disability will often set up a special needs trust funded by their life insurance policy. After the life insurance death benefit has been paid, those proceeds may be used to purchase an annuity, which ensures an ongoing stream of income. Since a disabled person typically can’t qualify for government assistance programs if they have more than $2,000 in their names, the trust holds the assets for them and pays for needed care. Since the special needs child is a beneficiary who doesn’t actually own the assets, he or she may still qualify for Medicaid or other federal and state assistance programs. 

    Different types of annuities and how they work

    If you are considering this option, you should know that there are many different kinds of annuity contracts designed to serve different tax-deferred investment and income distribution purposes. Here’s a brief overview of the key types of annuities and their features:

    Fixed and Variable

    With a fixed annuity, your money grows tax-deferred at a fixed interest rate, and this is the norm for life insurance annuities. It can be a predictable way to generate an ongoing stream of payments, however the returns may be lower than many market-based investments. A variable annuity, enables you to invest in the markets through a diverse array of investment options with the potential for growth on a tax-deferred basis. This can generate higher returns – and larger income payments – but your principal can go down in value as well. Variable annuities can also be quite complicated, so they are more suitable for sophisticated investors.

    Deferred and immediate

    You don’t have to start taking disbursements right away. If you’re close to retirement and receiving a life insurance payout, you may not need monthly payments while you’re still working. Deferred annuities let you put off payments for as long as you’d like. In doing so, you’ll also give your money more time to accumulate tax-deferred growth, making your eventual income payments larger than they might be with an immediate annuity.

    Lifetime and fixed-period

    lifetime annuity pays you lifetime income, and the longer you live, the more value you get out of it. However, when you die, the payments stop, even if the total income distributed doesn’t match the original sum put into it. If you don’t like the possibility of leaving money behind, you can get fixed-period annuities with terms of 10, 15, or 20 years. Payments won’t last indefinitely, but they may outlive you: if you pass away during the fixed period, benefit payments will continue to be paid to the beneficiaries you designate. 

    The pros and cons of annuities compared to other payout options

    Compared to a lump-sum distribution, you will have less cash at your immediate disposal, and it may take a long time to get back everything you put in. For example, at 6% a year, a $500,000 benefit will get you annuitized payments of $2,500 every month. At that rate, it will take almost 17 years to recoup the $500,000 you put in. And for all intents and purposes, that money is locked away: While you may be able to withdraw some of the principal if absolutely needed, you will have to pay early-withdrawal fees. Conversely, if you have a hard time managing money – or don’t trust your own spending habits – then the predictable structure with tax-deferred returns could be an option to consider for managing your money over the long term. And in the example cited above, you can come out farther ahead with every month you live past 17 years.

    Is this option right for you? While annuities are one predictable way to create income for life, they aren’t for everyone. It helps to gather information and consider all your options – in an unrushed manner – before making a decision. If you know that you will be the beneficiary of a life insurance policy, it’s worth your while to plan ahead by consulting with a trusted financial professional who can give you more specific information and guidance to make the right decision for your needs. is an information resource that can help you understand how to buy life insurance and annuities.

    Frequently asked questions what to do with a life policy payout

    What is the potential benefit of an annuity paid for with life insurance death benefit?

    It can complement the protection offered by a life insurance policy by turning the beneficiary's one-time income tax-free payout into lifetime income that's guaranteed.

    What is the difference between an annuity and a life insurance policy?

    Life insurance and annuities work differently but are closely related because they both help protect people from life-expectancy risk. A life insurance policy provides protection you for the risk of early death by providing an income tax-free payout to replace the income you would have otherwise earned to care for your family. Whether immediate or deferred, annuities provide monthly payments that last your entire life, which help protect you from the risk of longevity – and outliving your savings.

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    1 Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.

    Annuity guarantees are backed exclusively by the strength and claims-paying ability of the issuing insurance company.

    Variable annuities are long-term investment vehicles that involve certain risks, including possible loss of the principal amount invested. The investment return and principal value may fluctuate so that the investment, when redeemed, may be worth more or less than the original cost. Withdrawals of taxable amounts will be subject to ordinary income tax and possible mandatory federal income tax withholding. If taken prior to age 59½, a 10% IRS penalty may also apply. Withdrawals affect the variable annuity’s death benefit, cash surrender value and any living benefit and may also be subject to a contingent deferred sales charge.

    Variable annuities and their underlying variable investment options are sold by prospectus only. Prospectuses contain important information, including fees and expenses. Please read the prospectus carefully before investing or sending money. You should consider the investment objectives, risks, fees and charges of the investment company carefully before investing. Please contact your investment professional.

    Current tax law is subject to interpretation and legislative change. Tax results and the appropriateness of any product for any specific taxpayer may vary depending on the particular set of facts and circumstances. Entities or persons distributing this information are not authorized to give tax or legal advice. 

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