If you are set to receive a life insurance death benefit, you can decide how to receive this large payout. While taking a lump sum for everything at once is the most common choice, you have other options. For example, a life insurance annuity can break up the death benefit into ongoing future income.
Wondering if this approach may be right for you? Consider how annuity life insurance works, along with some potential advantages and disadvantages.
How Do Life Insurance Annuities Work?
An annuity is a contract that turns money into future income payments. A life insurance annuity uses the death benefit from a life insurance policy to fund that contract.
When you file a claim to receive the death benefit, you choose how you want the money paid. One option an insurance company may offer is a life insurance annuity. If you choose this option, the death benefit is converted into future income payments. The payment amount depends on the size of the death benefit and how long you want payments to last.
How Long Can a Life Insurance Annuity Last?
Life insurance annuity payments can be set up in one of two main ways.
Fixed Period Payments: You can choose to receive payments for a set period, such as 10 or 20 years.
- Payments last until the end of the selected period
- Payments stop once the guaranteed period ends
- If you die before all payments are made, remaining payments go to your beneficiaries
Lifetime Payments: You can also choose payments that last for your entire life.
- Payments continue no matter how long you live
- Payments may last decades
- If you pass away early, you may not receive the full death benefit
To reduce this risk, you can add a guaranteed minimum payment period. This means the annuity pays for your lifetime and also guarantees a minimum number of payments. For example, payments are made for at least 10 years to you or your beneficiaries.
How Payment Length Affects Income
The length of the annuity affects the monthly payment amount.
| Annuity Length | Monthly Income |
|---|---|
| Shorter term | Higher payment |
| Longer term | Lower payment |
A five year annuity pays more per month than a 20 year annuity because the death benefit is paid out over a shorter time. The insurance company will show income amounts for each option.
Life Insurance Annuity vs. Life Annuity
A life annuity and a life insurance annuity sound similar, but they work differently.
Life Annuity
A life annuity is purchased using personal savings or retirement funds, such as an Individual Retirement Account.
- Funded with your own money
- Paid as a lump sum or through deposits over time
- Provides guaranteed income for life
Life Insurance Annuity
A life insurance annuity is funded only by a life insurance death benefit.
- Funded by a life insurance policy death benefit
- Cannot be purchased with personal savings
- Can pay income for life or for a set number of years
A life annuity only offers lifetime payments. A life insurance annuity offers more flexibility in how long payments last. While other annuities may pay for a fixed period, those are different products than a life annuity.
| Feature | Life Insurance Annuity | Life Annuity |
|---|---|---|
| Availability | Only to the beneficiary of a life insurance policy death benefit. | For purchase by any individual. |
| Who Pays for the Annuity | The deceased who originally bought the life insurance policy. | The annuity purchaser. |
| Funding Options | All at once, using the life insurance death benefit. | Either in a single lump sum or with payments over time. Can use personal savings, investment values or retirement accounts. |
| Income Payment Options | Lifetime payments or installment payments over a fixed period. The beneficiary decides. | Lifetime payments only. |
| Taxes | Payments are partially taxed. The death benefit is tax-free. Amounts in excess of the death benefit are taxed as income. | Depends on the contract set-up. If bought using after-tax dollars, then the annuity income is partially tax-free. If bought using pre-tax dollars, income is 100% taxed. |
What Are Potential Benefits of a Life Insurance Annuity?
- Helps with Budgeting: Managing a five, six, or even seven figure payout can be overwhelming, especially during an emotional time. When you as a life insurance beneficiary a large lump sum may lead to spending decisions you later regret. A life insurance annuity spreads the death benefit into regular income over time, which naturally supports budgeting and helps the money last longer.
- Creates Ongoing Income: Life insurance is often used to replace a loved one’s income. A life insurance annuity can convert the death benefit into monthly payments that mirror what your loved one earned, effectively replacing their paycheck with steady annuity payments.
- Earns a Return To Extend the Insurance Payout: A life insurance annuity does more than divide the death benefit into equal payments. While the insurance company holds the funds, it pays a predetermined income based on the annuity setup. The death benefit makes up only part of the income stream, and the annuity structure can result in a larger total payout over time.
- Delays Taxes on Interest Earnings: Annuity payments include earnings on the death benefit, but income tax is not owed immediately. Taxes apply only to the added value as payments are received. This tax delay allows the balance more time to grow and support future income.
- Can Leave Money Behind for Your Beneficiaries: A life insurance annuity can be structured so that remaining installment payments continue to beneficiaries after your death, providing ongoing financial support.
What Are Potential Drawbacks of a Life Insurance Annuity?
- Delayed Death Benefit Payments: A life insurance annuity spreads payments over time instead of paying a lump sum. It may take years or decades to receive the full amount. If payments last only for your lifetime and you pass away early, you may not receive the entire death benefit.
- Limited Access To Funds: Early access is often restricted. Some contracts allow early cash outs at a reduced amount, known as a commuted value. Others cannot be reversed once payments begin.
- Taxes on Annuity Earnings: Life insurance death benefits are income tax free, but annuity earnings are taxable. A portion of each payment represents growth, which the IRS treats as taxable income.
- Lower Growth Potential: Annuities generally offer steadier returns but less upside. Investing on your own in stocks or mutual funds may provide higher growth, though with more risk.
How Are Life Insurance Annuities Taxed?
The IRS does not charge income tax on life insurance death benefits. You do not owe tax when you receive the death benefit or when you set up a life insurance annuity.
Once annuity payments begin, each payment is split into two parts:
- A return of the death benefit, which is not taxed
- Annuity earnings, which are taxed as income
You only owe income tax on the earnings portion of each payment.
For example, if your life insurance annuity pays $1,000 a month, the insurer may show that $750 comes from the death benefit and $250 from earnings. The $750 is tax-free, while you owe income tax on the $250. Your annuity company should provide an annual statement showing the taxable portion.
You only owe income tax when you receive earnings. If the money stays in the contract to grow, income taxes are deferred.
Maximize your earnings with smart tax planning. Request a Free Life Insurance Quote
Considerations When Choosing a Life Insurance Annuity
Once you choose a life insurance annuity, the decision can be difficult or impossible to reverse. It is important to think carefully about whether this is the best way to use the death benefit. The considerations below can help you decide if this option fits your situation.
Immediate Cash Needs & Savings
After a loved one passes away, you may face several immediate expenses, including funeral costs, medical bills, outstanding debt, and legal fees tied to settling the estate. Before choosing a life insurance annuity, confirm that you have enough savings to cover these expenses without relying on annuity payments.
Comfort Handling a Large Amount of Money
Consider how comfortable you feel managing a lump sum. If you worry the money could be spent too quickly, a life insurance annuity spreads the benefit into predictable annual payments. If you feel confident budgeting and managing the funds over time, an annuity may not be necessary.
Investment Knowledge & Options
Think about your experience with investing. If you already invest and feel comfortable growing the money on your own, you may earn more than you would through a life insurance annuity. If you prefer not to manage investments, an annuity handles this for you.
Future Income Needs
When setting up a life insurance annuity, you choose how long payments last and how much income you receive each year. This requires a clear understanding of your future budget. If payments are set too low, you could face an income gap later. A life insurance annuity works best if you are confident in your income needs or have other income sources to support you when needed.
Alternatives to a Life Insurance Annuity
There is no rush when deciding how to receive a life insurance death benefit. There is no deadline, and you can take the time you need to make this financial decision. While a life insurance annuity may work for some people, there are other ways to receive a death benefit settlement.
Common alternatives include:
- Leave the money with the insurance company and collect interest. You can withdraw the funds later, which may give you time to grieve before deciding how to use the death benefit.
- Take a lump sum and purchase your own annuity. For example, you could keep part of the benefit in cash and use the remaining amount to buy an annuity for income, rather than placing the full amount into a life insurance annuity.
- Purchase an annuity if one is not offered by the insurer. If the insurance company does not provide a life insurance annuity option, you can collect the death benefit as a lump sum and then use the funds to purchase an annuity on your own. This involves one extra step but can produce similar income.
Before deciding how to accept the death benefit, it may help to compare your options carefully and speak with a financial representative.
Conclusion
A life insurance annuity can turn a death benefit into steady income, but it is not right for everyone. The best option depends on your cash needs, comfort managing money, and long-term income goals. Comparing your choices and weighing the trade-offs can help you decide how to use the benefit in a way that fits your financial priorities.
Choose a life insurance annuity for continuing support. Request a Free Life Insurance Quote
