Buying life insurance can be an important way to help protect your family’s financial future, and if you’re like most people who have (or are thinking of getting) a policy, you’ve probably spent time thinking about how big a death benefit you need. But the way beneficiaries receive the death benefit can also affect your family's financial stability. When the insured person passes away, it's common for beneficiaries to receive a lump sum payout. But for some, a life insurance annuity is a better a payout option that can contribute to long-term financial stability.
Key takeaways
A life insurance annuity is not a type of policy or annuity; it’s a payout option for a life insurance policy that lets beneficiaries convert the death benefit into a stream of regular income, instead of taking a lump sum.
Beneficiaries can choose payments for a fixed period (such as 10 or 20 years) or for life; longer payout periods result in lower monthly payments.1
Life insurance annuities may provide greater financial stability and reduce the stress of managing a large inheritance.
Unlike traditional retirement annuities, a life insurance annuity is funded with an after-tax death benefit payment, so beneficiaries generally only pay taxes on any interest earned.
While annuity payouts offer predictable income with reduced concerns about market exposure, they provide less flexibility than a lump sum payment, and there are typically fees or other restrictions that limit access to larger amounts of cash if needed.
To make the right decision for your family, it’s important to understand the terminology
A life insurance annuity isn't a life insurance policy or other standalone financial product that you buy. It's also not exactly the same as a life annuity, in which you pay an insurance company to provide an income stream for the rest of your life.2
Instead, a life insurance annuity is a payout option offered by many life insurance companies on their policies. It allows the life insurance beneficiary to use the death benefit they receive to purchase an annuity. The beneficiary may choose a "life annuity" (see below) that provides guaranteed income payments for the rest of their life; but the payout can also be used to purchase other types of annuities that provide guaranteed income for a specifically defined period, such as 10 or 20 years. In either case, it may also be called “annuity life insurance,” because the life insurance policy’s death benefit is used to fund an annuity contract that provides structured income.
What is the difference between life insurance annuities and life annuities?
Life insurance annuities and life annuities might sound like synonyms, but there are some distinct differences.
Life annuities
A life annuity is an insurance product generally used for retirement planning, because it can work like a pension to provide a stream of income for the rest of your life, regardless of how long you live.
There are several types of annuities, and they each work differently. With an immediate annuity, you pay a lump sum and have payments start immediately (or within a year), making it a popular choice for retirement income planning. With a deferred annuity, you make either a lump sum or a series of payments in what’s known as the accumulation phase; one or more years later, during the distribution or payout phase, you start to receive payments, typically in monthly or quarterly installments, for the duration of the contract.
Annuities can also differ in terms of how funds grow in the annuity account. A fixed annuity provides a guaranteed rate of return, while variable annuities provide returns that fluctuate depending on market conditions. Other types of annuities, such as fixed index and RILA annuities, are designed to let you take advantage of market growth while limiting your investment risk. In any case, funds in an annuity generally grow tax-deferred, so returns are only taxed as you start making withdrawals.
Once you start taking income from an annuity, you can opt to receive payments for the rest of your life, or just for a specified period (in which case it isn’t actually a life annuity; it's a fixed-period annuity). With a life annuity, the insurance company calculates your life expectancy (among other considerations) and then divides payments accordingly.3 While this can ensure a stream of income for as long as you live, the longer expected payout generally coincides with lower monthly payments.
If you choose a specific period payout and die before that period ends, the remaining payments may go to a beneficiary. Finally, standard annuity contracts generally do not adjust payments for inflation, which may reduce your purchasing power over time. Some annuity companies will let you opt for payments that increase to account for inflation, but this will generally result in lower payments at the start.
Life insurance annuities and how they work
Traditional annuities can be purchased with pre-tax dollars through a qualified retirement plan, or with after-tax dollars as a nonqualified annuity; the tax treatment depends on how the contract is funded. By contrast, a life insurance annuity payout is funded by a life insurance death benefit, which is generally not taxable as income to the beneficiary, although any interest or earnings paid with the proceeds are generally taxable. Because tax rules can vary based on the contract, payout method, and beneficiary’s circumstances, beneficiaries should consult a tax professional before choosing or changing a payout option.
Having said that, a life insurance annuity basically works like any other kind of “single premium” annuity (i.e., an annuity purchased with a single lump-sum payment): The death benefit is the lump sum used to purchase the annuity, which effectively spreads payments out over several years. But it’s important to remember that a longer expected payout generally coincides with lower monthly payments.
That's why younger people — i.e., those before retirement age — generally choose to have their annuities paid out over a shorter, fixed time frame. For example, a surviving spouse with teenage children might choose a 10-year payout that provides income until the children have graduated college. If children are younger, they might choose a longer payout period with lower payments. On the other hand, a beneficiary closer to retirement age may well choose to take a lifetime payout, which effectively provides the same benefits as a lifetime pension.
Pros and cons of a life insurance annuity compared to a lump sum payout
Neither type of payout is inherently better or worse than the other. Most people choose a lump sum life insurance payout, presumably because they feel it’s a better fit for their needs. But for others, an annuity payout is the better choice. Here are some things to consider.
It’s not uncommon for a beneficiary to receive a life insurance payout of $1,000,000 or more. That amount can be overwhelming to many people, especially as they’re still grieving the loss of a loved one. They have to make many important decisions about the money: Should it be invested? How should I invest it? What if my investments lose money? How can I get regular payments to replace the paycheck my spouse used to provide?
These types of issues can create anxiety for people not used to managing large sums of money. But the guaranteed income stream from an annuity payout can provide an effective answer to all those questions and help foster the kind of financial well-being most life insurance buyers want for their loved ones.
But there are some disadvantages as well. To start with, an annuity is generally not a liquid investment: If you want to take out funds beyond your regularly scheduled payments — for example, to put a down payment on a house — there are typically penalties and other limitations on what you can withdraw.
Annuity products also have fees that can diminish your earnings, and there may be what's known as an "opportunity cost": If you took the lump sum option from a life insurance death benefit, you could potentially invest that amount and earn more than what an annuity pays out. However, there's also the risk that your investments could decline in value. Annuities — especially a fixed annuity that pays a guaranteed interest rate — can provide more certainty, and even eliminate investment risk.
Comparing life insurance payout options
Annuity payout | Lump sum payout |
|---|---|
Provides an income stream over time, potentially for the rest of your life | Provides the entire death benefit in a single large payment |
Grows on a tax-deferred basis, potentially surpassing the lump sum amount, then earnings can incur taxes during withdrawals/payouts | Is taken tax-free, but if you invest the lump sum amount, you can incur taxes on any gains |
Guardian can help
Want to protect your financial future but aren’t sure how life insurance and annuities fit into your situation? Guardian can connect you with a financial advisor who will listen to your needs and recommend different life insurance and/or annuity options to fit your needs and your budget.
Frequently asked questions about life insurance annuities
An annuity in life insurance is one of two main payout options from a life insurance policy. Life insurance beneficiaries often receive money from the policy as a lump sum payment, but they can also choose to purchase an annuity with the death benefit. In turn, that can provide a guaranteed stream of regular income (e.g., every month or quarter) for a set number of years, or even for the rest of their life.
One could achieve essentially the same result by using the death benefit to purchase a single premium immediate annuity contract (or SPIA) from an annuity company: right after the annuity is funded, the distribution phase (i.e., annuity payments) begin and continue for the duration of the chosen payout period.
Annuity payouts can vary significantly, between $446 and $1,150 per month, depending on the specifics of the product.4 For example, an immediate annuity generally pays lower monthly amounts than a deferred annuity, as the latter has time for the initial investment to grow. But as one example, according to Annuity.org, a $100,000 annuity purchased by a 60-year-old man could yield $848 per month if he started payments at age 65, or $1,302 per month if he waited until age 70.5