A life insurance annuity is a benefit payment option for a life insurance policy. If you are a 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, when the policyholder dies, the insurance company will place your payout into an annuity contract. You will then receive regular payments and interest against the balance until the account is emptied. Here’s how it works.
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What Is a Life Insurance Annuity?
Every life insurance policy has three elements: the insured, the payout, and the beneficiary. The insured is the individual covered by the life insurance policy. The payout is the amount the insurance policy pays when the insured dies. The beneficiary is the person who receives this payout.
For example, say that 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.
A life insurance annuity is a way in which a beneficiary can choose to receive their payout.
Ordinarily, a life insurance policy issues its payout in a lump sum. In our case above, for example, Sally would typically receive 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 issuing it directly to the beneficiary. The account then functions as a regular annuity. The beneficiary will receive regular payments while, at the same time, the account’s principal accrues interest.
Typically, these payments continue for a set period of time until the account is exhausted. Some insurers also advertise lifetime life insurance annuities, which would generate payments for the lifetime of the beneficiary.
In the example above, Sally might choose to receive her payout in the form of a life insurance annuity. If so, the life insurance company would issue her a $1 million annuity contract upon Alex’s death. It would issue Sally a regular monthly payment while also paying interest into the annuity account based on the contract’s underlying interest rate until, eventually, the contract has paid out both its principal and collected returns.
With a life insurance annuity, the beneficiary pays income taxes on the interest portion of all payments. They do not pay taxes on the portion of their payments that came 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 on the portion of her annuity income that comes from the $1 million principal, but she would pay income tax on the portion of that income that comes from the account’s interest.
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. You purchase it either in one lump sum or with periodic investments over time. For example, you might invest $1 million all at once in an annuity contract or you might invest $100,000 per year over a decade. 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. You select it as an option if you are 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 (one which issues payments for a specific period of time) or a lifetime annuity, based on its terms.
Bottom Line
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.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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