Life Insurance

What Is A Life Insurance Annuity?

If receiving a death benefit as a single lump sum sounds too daunting, beneficiaries of a life insurance payout can opt to receive their money as an annuity. 

What Is A Life Insurance Annuity

An annuity is an income-producing investment vehicle that you can purchase from an insurance company that protects you from the risk of outliving your income. Many people use the steady payments produced by their annuity to supplement their retirement income. 

A life insurance annuity is an option if you are the beneficiary of a death benefit and want to spread out payments instead of receiving a single larger payment. You receive a series of payments according to the contract, choosing monthly, quarterly, or annual payments. The size of the payments you receive from an annuity depends on the amount of money you invested and the payment period. You can choose to receive payments for the rest of your life or for a specified number of years. 

You have a number of choices to make when you decide to receive life insurance money through a life insurance annuity. 

Life Insurance Annuities vs. Life Annuities: Similar, But Different

Life insurance annuities and life annuities sound the same, but there are key differences. A life annuity is a standalone product designed to supplement the annuity owner’s retirement income. You can choose to make a single lump-sum payment or a series of premium payments to fund a life annuity. The balance earns interest at a variable or fixed rate, and you receive regular payouts for as long as you live. 

The beneficiaries of a life insurance policy receiving a death benefit can choose a life insurance annuity as a form of payment as an alternative to a single lump-sum payment. When the beneficiary of a life insurance policy decides to participate in a life insurance annuity, they receive guaranteed incremental payments, which may feel more manageable than a large one-time payout. 

How Do Life Insurance Annuities Work?

Annuities allow beneficiaries of a death benefit options in how to receive the payout, whether in regular payments over a set period of time or over the beneficiary’s lifetime. If receiving a death benefit as a single lump sum sounds too daunting, beneficiaries of a life insurance payout can opt to receive their money as an annuity. Depending on the insurance company’s options, the beneficiary may be able to put their death benefit payout into a fixed-period annuity or lifetime annuity.

With a fixed-period annuity, the beneficiary of the death benefit chooses how long to receive regular payments from the payout. The insurance company provides a contract stating that the beneficiary can receive this income for the selected period of time. On the other hand, a lifetime annuity provides income for the beneficiary’s entire life, no matter how long they live. 

Beneficiaries may also be able to choose between a variable annuity and a fixed annuity as a way to receive the death benefit payout. Both annuity types offer tax-deferred growth. A fixed annuity grows at a fixed rate of interest, whereas a variable annuity allows the owner to put the funds into various investments with the potential for larger growth, but the possibility of some risk. 

Potential Benefits of Life Insurance Annuities

While many people choose to receive a death benefit in a single payment, receiving a death benefit payout as an annuity has several benefits. A life insurance annuity may be the right choice if:

  • The lump-sum payment from a death benefit is overwhelming. If the beneficiary feels insecure about their ability to manage a large amount of money, or if they need the money to last throughout their lifetime and aren’t sure how to ensure that they’ll have ongoing income as a result of the death benefit, a life insurance annuity could be the ideal solution. 
  • The money isn’t needed to cover immediate expenses. If the beneficiary doesn’t need to use the death benefit to take care of end-of-life expenses like medical bills or funeral and burial costs, it may make sense to choose incremental payments instead of a lump sum. 
  • The beneficiary wants the money to earn interest. Annuities earn interest and choosing a life insurance annuity can help a beneficiary diversify their investments

Potential Downsides of Life Insurance Annuities

There are several potential drawbacks of choosing an annuity as a death benefit payout instead of a lump sum payout. Annuities can be complex and beneficiaries may have to pay fees and taxes, whereas a lump-sum payout to a beneficiary is usually tax-free. There are a few key disadvantages of life insurance annuities for beneficiaries to evaluate:

  • It takes time to receive the full death benefit amount. Annuities pay only a small portion of the total death benefit amount. It could take decades for the beneficiary to receive the entire death benefit. 
  • Annuity fees and taxes can be expensive. Insurance companies charge a number of fees to manage the money in the annuity. After choosing an annuity, the beneficiary receives only the periodic payments and they don’t have access to the principal. Accessing additional funds may trigger high early withdrawal fees, and interest produced by the annuity is taxable. 
  • As an investment, annuities provide a low rate of return. Death beneficiaries who invest their lump sum payment are likely to earn more interest by investing the money on their own than they would earn if they choose a life insurance annuity. 

How Do Life Annuities Work?

A life annuity provides regular payments according to the annuity owner’s preferences. This is a stand-alone product represented by a contract with an insurance company. Annuity owners can choose monthly, quarterly, annual, or semi-annual payouts. Life annuities are not associated with anyone’s life insurance policy. 

For many people, the risk of outliving their savings inspires the purchase of a life annuity. This type of investment works as longevity insurance, as the annuity provides dependable income that the account owner can’t outlive. Many people purchase life annuities to supplement their income during retirement. During the first phase of an annuity, the buyer funds the annuity with a lump-sum payment or premium payments spread out over time. The annuity grows as it earns interest.

During the second phase, the annuity owner receives regular distributions according to the annuity contract’s terms, providing the annuitant with regular payments until they die or another triggering event occurs. In some cases, payments may continue to the annuity owner’s beneficiary or estate if there’s a rider providing additional benefits. 

Types of Life Annuities

There are several types of life annuities available to investors. Each life annuity type provides the annuitant with various benefits. 

An annuity may be immediate or deferred, which refers to the time when payments to the annuitant begin. An annuity buyer must decide whether they want to start receiving payments immediately or wait until a future date. Deferring payments allows the annuity balance to earn interest tax-deferred. Over time, interest accumulation could help the annuity grow large enough that the annuitant would receive larger periodic payments than if they had an immediate annuity. 

With an immediate annuity, payments begin as soon as the buyer makes the lump sum payment to the insurance company. Immediate annuities and deferred annuities can be fixed or variable, depending on the account owner’s financial goals. 

Fixed annuities are a lower risk option than variable annuities since they provide the customer with a fixed rate of return. A fixed annuity is designed to protect the principal while providing reliable income payments and insulating the purchaser from the volatility of the stock market. 

Exposure to inflation is a non-negotiable risk, but a cost of living (COLA) rider may provide some protection. A fixed annuity may be easier for the customer to understand since there are fewer moving parts than with a variable annuity. 

Variable annuities may work better for those with a higher tolerance for risk who want to increase their retirement savings but also want a steady income stream. Individuals who’ve maxed out their other retirement account contributions may choose a variable annuity to take advantage of tax-free growth inside the account. However, unpredictable returns that fluctuate with the stock market could cause the portfolio to lose value. 

Variable annuities may also offer an optional death benefit or living benefit that could help annuitants reach their financial goals. Variable annuities come with higher fees and adding riders can increase the costs to the investor.

Since annuities can help supplement retirement planning, they may help to identify the gaps in an individual’s financial plan. Risk tolerance plays a major part in deciding whether a fixed or variable annuity may work best for an individual.

Qualified and non-qualified annuities differ in regards to when and under what conditions an annuity owner may pay taxes on the money used to fund the annuity, as well as when they must begin to receive disbursements from the annuity. Interest earned on an annuity is tax-deferred. 

Qualified annuities are funded with pre-taxed income that becomes taxable when the annuitant starts receiving money from the annuity. Annuitants may contribute to a qualified annuity with money from a 401(k) or IRA. If the annuitant turned 70.5 years old prior to January 1, 2020, they must begin taking disbursements at age 70.5. However, the IRS recently raised the age to 72.5 for anyone turning 70.5 after January 1, 2020. The IRS limits the amount of income a person may invest in a qualified annuity each year, and this amount could also change depending on your marital status.

Non-qualified annuities are funded with after-tax income and qualified withdrawals are tax-free. Contributors may fund a non-qualified annuity with funds from a Roth IRA or Roth401(k). There are no rules about when a non-qualified annuity owner must begin taking distributions. However, if a withdrawal is taken within 5 years from the time the Roth IRA was established, regardless of the owner’s age, it may be subject to a penalty and taxed as income.

However, there are exceptions to the penalty, such as funds withdrawn for a first-time homebuyer or college expenses. Qualified withdrawals, which are withdrawals occurring after the customer is 59.5 years old and the account has been open for at least five years, are income tax-free because the account owner has already paid taxes on the principal.

Both qualified and non-qualified annuities impose a 10% early withdrawal penalty if the annuitant takes money out of the account before age 59.5, unless the annuitant becomes disabled, dies, or meets one of the exceptions set by the IRS. 

Non-qualified annuity owners can transfer funds between variable and fixed annuities without incurring early withdrawal penalties. Qualified annuity owners can make similar transfers, but they can only use tax-deferred funds inside the annuity. 

Potential Risks of Life Annuities

An annuity is unique among products in that it can provide a steady stream of income for the account owner’s entire lifetime, no matter how long they live. If managed properly, an annuity can provide returns similar to other assets with less volatility. Annuities provide a number of financial benefits to annuitants, but it’s important to be aware of the downsides of this type of contract as well. 

In general, annuities are safe, but they are technically insurance products and not appropriate for short-term objectives. Different annuity types carry various amounts of risk such as: 

  • Inflation: In the face of rising inflation, the risk that an annuity’s rate of return may be outpaced and lose value over time is a serious concern. 
  • Liquidity: Annuities are inherently illiquid. Taking money out of an annuity brings early withdrawal penalties of 10%. The insurance company may also charge additional administrative and surrender fees. 
  • Early death: If an annuitant doesn’t live as long as they expect and they don’t have a death benefit rider, the principal held in an annuity could be lost to the insurance company. 
  • Complicated: An annuity is a complicated contract between an individual investor and an insurance company. It can be difficult for even experienced consumers to fully understand the terms and rules of their annuity. 

Combining Life Insurance and Annuities

A life insurance policy provides the insured person’s beneficiaries with a tax-free death benefit that they can use for any reason, including paying funeral and burial expenses. As an individual ages, their need for life insurance that would provide financial support for their young family may decrease, but the desire to leave an inheritance or provide for the next generation can be fulfilled by purchasing a life insurance policy.  

Life annuities can benefit the annuitant while they are still alive as an important part of a retirement income strategy. Those with access to a lump sum of money may exchange their cash for an annuity that provides regular income that they can’t outlive. 

Combining a life insurance death benefit with an annuity provides the benefits of both insurance products. During the annuitant’s lifetime, they receive a steady stream of income from an account designed to help them reach their financial goals. When the annuitant dies, their beneficiaries receive a death benefit that can be used for any reason. 

Life insurance and annuities are both important financial tools that provide enough versatility to become an important part of an overall financial plan that includes a solid retirement strategy. Consult a financial planner to understand how life annuities and life insurance can work together to help provide a lifetime of financial stability.