What Is a Life Insurance Annuity?

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 the money you put in into future income payments. Life insurance annuities use the death benefit from a life insurance policy to fund an annuity contract.

When you file a claim to collect the death benefit, you choose how you want to receive the money. An insurance company may offer a life insurance annuity as an option. If you choose the annuity, you then collect future income payments based on the size of the death benefit. You also choose how long you want the annuity life insurance payments to last.

How Long Can a Life Insurance Annuity Last?

If you're wondering how annuities work for payments, you have two main options. First, you could pick a set period of payments, such as income for 10 years or 20 years. These payments last up until the end of the guaranteed payment. At that point, the life insurance annuity income stops. If you die before collecting all the scheduled payments, they continue to your beneficiaries.

Another option is to set up a life insurance annuity guaranteed to last your entire life. No matter how long you live, you will continue to receive payments. The payments could potentially last decades. However, if you pass away soon after setting up the life insurance annuity, you might not collect the full death benefit in payments. You could include a minimum number of payments with the life option. The annuity is guaranteed to last your entire life but also makes a minimum number of payments in case you die early. For example, the annuity will make at least 10 years of payments either to you or your beneficiaries.

You pick how long you want the life insurance annuity payments to last and whether there is a guaranteed minimum number of payments. The longer the life insurance annuity lasts, the lower the monthly income. A five-year life insurance annuity will pay more per month than a 20-year life insurance annuity because it pays out the entire death benefit over a shorter period. The insurance company will show you how much income you would receive under the various options.

Life Insurance Annuity vs. Life Annuity

A life annuity might sound like the same thing as a life insurance annuity, but they follow different arrangements. You buy a life annuity using your personal savings or a transfer from retirement funds, like an Individual Retirement Account. You can pay for a life annuity with a single lump sum or many deposits over time. The life annuity then turns these payments into guaranteed income for the rest of your life.

While a life annuity has similarities to a life insurance annuity, there are a couple of crucial differences. First, you buy a life annuity on your own with an amount you determine. You can only set up a life insurance annuity using the death benefit of a life insurance policy.

In addition, a life annuity only offers guaranteed payments for life. A life insurance annuity can make lifetime payments or payments for a set number of years. You could buy an annuity on your own that only pays for a set number of years, known as a fixed-period annuity. However, this is a different product than a life annuity.

What Are Potential Benefits of a Life Insurance Annuity?

• Helps with budgeting: Figuring out how to properly manage a five, six or even seven-figure payout can be challenging. When you as a life insurance beneficiary receive a death benefit, chances are you're dealing with a wave of significant emotions and stress. As a result, receiving all the money in a lump sum can lead to spending that you might regret later. With a life insurance annuity, you turn this large payment into ongoing income split over many years. It naturally forces you to budget and helps make the money last.
• Creates ongoing income: One of the top reasons to buy life insurance is to replace a loved one's ongoing income. You could set up a life insurance annuity that turns the death benefit into monthly income, similar to what your loved one was earning. You replace their paycheck with annuity life insurance payments.
• Earns a return to extend the insurance payout: A life insurance annuity doesn't just split the death benefit into equal payments. As long as the insurance company has your money, it will pay you a pre-determined income. How this works depends on the life insurance annuity set-up. The death benefit itself represents just a portion of the income stream. The annuity in whole creates a larger total payout.
• Delays taxes on interest earnings: Life insurance with annuity payments reflect earnings on the death benefit, but you don't immediately owe income tax on them. You only owe income tax on the added value when you collect income payments. The tax delay gives your balance more time to grow and build future income.
• Can leave money behind for your beneficiaries: A life insurance annuity doesn't just create income for yourself. You could also set it up so future installment payments continue to your beneficiaries.

What Are Potential Drawbacks of a Life Insurance Annuity?

• Delays the death benefit payment: By design, a life insurance annuity stretches out the life insurance death benefit payment. It could take years or even decades to receive all the money you could have gotten in a lump sum immediately. If you pick an annuity that only makes payments during your lifetime and pass away soon after signing up, you might not collect the full death benefit in payments.
• Restricts early access to the annuity balance: A life insurance annuity limits your ability to cash out early. Some contracts pay a lesser amount, called a "commuted value," if you cash out ahead of schedule. Others are irreversible, meaning you can't access the value once you start the annuity payments.
• You owe taxes on the annuity earnings: You receive a life insurance death benefit income tax-free but owe income tax on the annuity payout amounts beyond it. When you receive annuity income, part of your payment represents earnings, which the IRS taxes.
• You could earn a higher return elsewhere: While annuity life insurance earns a return to grow your money, it's usually not the highest. You might be able to grow the death benefit even more by investing on your own in stocks, mutual funds or other assets. A life insurance annuity offers a more certain return but less upside.

How Are Life Insurance Annuities Taxed?

The IRS does not charge income tax on life insurance death benefits. You will not owe any tax for receiving the death benefit or setting up the life insurance annuity.

Going forward, you will collect annuity income payments. The insurance company will divide the payments between a return of the death benefit plus the annuity earnings. You receive the portion from the death benefit tax-free. However, you owe income tax on the earnings.

For example, your life insurance annuity pays $1,000 a month. The insurer shows that $750 is from the death benefit and $250 is from the earnings. You would receive $750 tax-free and owe income tax on the $250. Your annuity company should give you a yearly statement showing what you must declare as taxable income from the life insurance annuity.

You only owe income tax when you receive the annuity earnings. As long as the money stays in the contract to grow for the future, you delay income taxes.

Considerations When Choosing a Life Insurance Annuity

Once you select the annuity life insurance option, this decision can be challenging, if not impossible, to reverse. Consider carefully about whether this is the optimal way to use the death benefit. Here are some considerations to help you determine whether a life insurance annuity makes sense.

Immediate Cash Needs & Savings

After a loved one passes away, you could owe several final expenses, such as covering the funeral, paying off medical bills and other debt, and handling legal fees to process the deceased's will and estate. Before committing to a life insurance annuity, make sure you have enough savings to cover these bills.

Comfort Handling a Large Amount of Money

Do you feel comfortable budgeting all the money from a death benefit? If you're worried about the money being spent too quickly, a life insurance annuity immediately puts it into an annual budget. If you think you could split the money up properly to make it last, you might not need the life insurance annuity option.

Investment Knowledge & Options

How comfortable are you with investing? If you think you could find good ways to grow the money and are already investing, then you might be able to earn more yourself versus a life insurance annuity. If you don't want to worry about investing the death benefit, a life insurance annuity takes care of it for you.

Future Income Needs

When you set up a life insurance annuity, you pick how many years you want the payments to last and set your annual annuity income. How comfortable are you in knowing what your budget will look like? If you underestimate, you could have a shortfall from the life insurance annuity income. A life insurance annuity makes more sense if you're confident in your income needs or have other ways to make money during years when your income is too low.

Alternatives to a Life Insurance Annuity

There is no rush or deadline for how life insurance works with paying a death benefit. You can take all the time you need with this important financial decision. There is no time limit for choosing how to use a life insurance death benefit. While a life insurance annuity can be helpful, there are other options for receiving a death benefit settlement:

• Keep the money with the insurance company and only collect interest. You could then withdraw the cash at your convenience. This would give you time to grieve before you figure out how to use the death benefit.
• Collect a lump sum and then use part of the money to buy your own annuity. For example, you could keep 50% of the death benefit in cash and use the remaining 50% to buy an annuity for income versus putting everything into a life insurance annuity.
• If the life insurance company doesn't offer a life insurance annuity option, you could first collect the death benefit as a lump sum. Then, you could use that money to buy your own annuity. You'd take one extra step to create the same income as a life insurance annuity.

Make sure you're adequately compared before deciding how to accept the death benefit. Consider meeting with a financial representative first to discuss your options.