What Is a Life Insurance Annuity?

A life insurance annuity is a payout option for life insurance benefits. If you are the beneficiary of a life insurance policy, you may have the option to receive your payout in the form of a life insurance annuity. In this case, the insurance company will place your payout into an annuity contract upon the policyholder’s death. You then receive regular payments and interest against the balance until the account is empty. However, there are some considerations you should make before deciding if a life insurance annuity is right for you.

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What Is a Life Insurance Annuity?

Every life insurance policy has three elements: the insured, the beneficiary and the payout.

Insured: The individual covered by the life insurance policy.
Beneficiary: The party receiving the payout.
Payout: The amount the insurance policy pays when the insured dies.

For example, Alex purchases a $1 million life insurance policy and names Sally as his beneficiary. If and when Alex dies, Sally will receive a $1 million payout from the life insurance policy.

Sally then has a few options for her payout method, including a life insurance annuity. Ordinarily, a life insurance policy issues a lump sum payout, which would result in Sally receiving a $1 million check from the insurance policy.

However, sometimes a life insurance company allows beneficiaries to receive their payout as an annuity. When they do, the payout is placed in an annuity account instead of being issued directly to the beneficiary. The account then functions as a regular annuity, with the beneficiary receiving regular payments while the account’s principal simultaneously accrues interest.

Typically, these payments continue for a set period of time until the account is depleted. Some insurers also advertise lifetime life insurance annuities, which would generate payments for the beneficiary’s lifetime.

Using the example above, Sally may choose to receive her payout via a life insurance annuity. In this case, the insurer issues her a $1 million annuity contract upon Alex’s death. Sally will receive a regular monthly payment while also paying interest into the annuity account based on the contract’s underlying interest rate. This continues until the contract has eventually paid out both the principal and its collected returns.

Tax Treatment of Life Insurance Annuities

Taxes are another important consideration.

With a life insurance annuity, the beneficiary pays income taxes on the interest portion of all payments. However, they do not pay taxes on the portion of their payments from the policy payout.

Returning to the example above, Sally’s annuity payments would involve both her $1 million principal and the account’s interest. She would not pay income tax on the portion of her annuity income that comes from the $1 million principal. But she would pay income tax on any income resulting from the account’s interest.

Payout Options for Life Insurance Annuities

A woman inquiring on the phone about the differences between a lifetime annuity and a life insurance annuity.

When a beneficiary receives a life insurance payout, they may have the option to take the proceeds as a life insurance annuity rather than a lump sum.

Choosing an annuity allows the payout to be distributed over time through regular payments instead of one large deposit. This option can help beneficiaries manage the funds more gradually while creating a steady source of income. This is especially favorable if they prefer predictable payments over handling a large sum all at once.

Life insurance annuities typically come with several payout structures.

Fixed period annuity. A fixed period annuity pays income over a set number of years, such as 10 or 20, until the entire balance is paid out.
Lifetime annuity. A life annuity continues making payments for as long as the beneficiary lives, even if the total received exceeds the original policy value.
Term life certain. Some contracts include a term certain life option, guaranteeing payments for either the beneficiary’s life or a set period, depending on which is longer.

The right structure ultimately depends on factors like the beneficiary’s age, income needs and comfort with long-term commitments.

Each payout option carries different advantages. A lump sum provides immediate access to the funds upfront, but it also places responsibility on the beneficiary for investing or managing that money.

In contrast, annuity payments enable financial discipline and give you the opportunity to earn interest while the balance remains with the insurer. The trade-off is that access to the funds is limited. Additionally, it’s often difficult or impossible to change your payout method once it is chosen, so be sure to carefully evaluate your options before making a decision.

Taxes also work differently for life insurance annuities. The original death benefit portion of each payment is generally not taxable because it represents the insurance payout. However, any interest earned within the annuity is treated as taxable income. This means only the growth on the funds is taxed, not the underlying principal.

Beneficiaries should weigh the tax implications and payment duration against their personal financial goals before deciding how to receive life insurance proceeds.

Life Insurance Annuity vs. Lifetime Annuity

A lifetime annuity and a life insurance annuity are often confused due to their similar names. However, they are unrelated assets.

A lifetime annuity is an annuity contract that can be purchased as either a lump sum or via periodic investments over time. For example, you may invest $1 million all at once in an annuity contract, or you may choose to invest $100,000 annually over a ten-year period. The value of the annuity grows over time based on the contract’s underlying interest rate and your total investment.

Then, at some point, the lifetime annuity enters annuitization. Once that begins, the contract issues fixed payments for the rest of the holder’s life. The amount depends on the contract’s value, its underlying interest rate, the holder’s life expectancy and when the holder begins to collect.

By contrast, a life insurance annuity is a way of receiving a life insurance payout if you’re the beneficiary under someone else’s life insurance policy. Once the policyholder dies, you receive an annuity funded by the policy’s payout. The size of this contract is based on the underlying life insurance policy and its interest rate is set by the terms of the contract. This annuity contract may be a term certain contract or a lifetime annuity, depending on its terms.

Bottom Line

A life insurance policy beneficiary checking to see if they have the option to receive payouts in the form of a life insurance annuity.

A life insurance annuity is a way to get your benefits under a life insurance policy. Once the policyholder dies, the life insurance company will roll your benefits into an annuity contract. You will then receive payments for a period of time based on the contract’s underlying principal and interest.

Annuity Investing Tips

Annuities are often considered a safe investment. But this insurance product also carries risk. Here are eight common reasons why an annuity may not be a good investment for you.
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