What a life insurance annuity does

A life insurance annuity is a contract where you give an insurance company a lump sum of money, and in return they pay you a fixed amount at regular intervals — usually monthly — for the rest of your life. The insurance company takes the risk that you will live longer than expected; you take the certainty that you will not run out of money.

The payments you receive are partly a return of your own money and partly earnings the insurance company made by investing what you gave them. Because the insurance company pools risk across many customers, some of whom die sooner than average, they can afford to pay you more each month than you would earn if you invested the money yourself.

Life insurance annuities are different from other annuities because they are specifically designed to last your entire lifetime, rather than for a set number of years or until a specific date. The insurance company's obligation ends only when you die.

Key Takeaways

  • You pay a lump sum to an insurance company and receive fixed monthly payments for life, regardless of how long you live.
  • The monthly payment amount is calculated based on your age, gender, current interest rates, and the size of your initial payment.
  • Once you begin receiving payments, you cannot get your remaining balance back as a lump sum, though some contracts allow payments to continue to a beneficiary after you die.
  • Life insurance annuities offer certainty about income but provide no growth potential and no flexibility if your financial situation changes.

How the payment amount is determined

The insurance company calculates your monthly payment using four main factors. Your age at the time you purchase the annuity matters most: the older you are, the higher your monthly payment, because statistically you have fewer years left to receive payments. A 65-year-old will receive more per month than a 55-year-old who paid the same lump sum.

Your gender also affects the payment. Women typically receive lower monthly payments than men who paid the same amount, because women have longer average life expectancy. Some states have restricted this practice, so the difference varies by location and insurance company.

Current interest rates influence the calculation significantly. When interest rates are high, insurance companies can earn more by investing your money, so they can afford to pay you more each month. When rates are low, monthly payments are lower. This is why two people buying the same annuity at different times may receive different payments.

The size of your lump sum is straightforward: a larger payment to the insurance company produces a larger monthly income. The relationship is direct — if you double the amount you pay in, your monthly payment roughly doubles.

The difference between when ready and deferred annuities

An when ready annuity begins paying you within one month of purchase. You hand over your lump sum and the payments start almost right away. This is the most common type of life insurance annuity and is often used by people who have just retired and want to convert savings into income when ready.

A deferred annuity is purchased years before you need the income. You pay the lump sum now, but the insurance company does not begin monthly payments until a date you choose — perhaps 10 or 20 years later. During the waiting period, your money grows, and when payments finally begin, they are larger than they would have been if you had bought an when ready annuity with the same amount.

Deferred annuities are less common for life insurance purposes because they require you to commit money for a long time without access to it. They are more often used as a way to set aside money for a specific future date, such as when you plan to stop working.

What happens to your money after you die

The basic life insurance annuity pays you a fixed amount each month for your entire life and stops when you die. The insurance company keeps any remaining balance. This is the trade-off for receiving payments that are may provide to last as long as you do — the company needs the possibility of keeping some of your money in order to afford those guarantees.

Many people find this unacceptable, so insurance companies offer variations. A joint and survivor annuity continues paying a surviving spouse (usually at a reduced rate, such as 50 or 75 percent of your original payment) after you die. This costs more upfront because the insurance company's obligation lasts longer.

A period-certain annuity guarantees that payments will continue for a minimum number of years — often 10 or 20 — even if you die before that period ends. If you die in year 3 of a 10-year period-certain annuity, your beneficiary receives the remaining 7 years of payments. After the period ends, payments continue for your lifetime as usual.

Some contracts offer a return-of-premium rider, which means if you die before receiving back the full amount you paid in, your beneficiary gets the difference. This may provide costs extra and reduces your monthly payment.

How taxes work on annuity payments

The tax treatment of your annuity payments depends on where the money came from before you bought the annuity. If you used after-tax money (money you already paid income tax on), each monthly payment is split into two parts: a return of your own principal, which is not taxed, and earnings, which are taxed as ordinary income. The insurance company provides a calculation showing what portion of each payment is taxable.

If you used pre-tax money from a retirement account such as a traditional IRA or 401(k), the entire monthly payment is taxed as ordinary income. You already received a tax deduction when the money went into that account, so the government taxes you when you take it out.

If you used Roth IRA money, the payments are generally not taxed, because you already paid tax on the money when you contributed it. However, the rules for converting a Roth IRA into an annuity are complex and vary by situation.

You do not owe taxes on the annuity until you actually receive the payments. There is no annual tax bill while the contract sits inactive.

Comparing life insurance annuities to other income sources

A life insurance annuity provides may provide income that does not depend on market performance, your investment decisions, or how long you live. Social Security offers similar certainty, but the amount is usually smaller and you must wait until a specific age to claim it. A life insurance annuity can start when ready and can be as large as your savings allow.

Unlike a bond or dividend-paying stock, an annuity offers no growth. Your monthly payment is fixed and does not increase with inflation or rising interest rates. If inflation rises significantly, the purchasing power of your payment shrinks over time. Some annuities offer cost-of-living adjustments, but these cost extra and reduce your starting payment.

Unlike a savings account or investment portfolio, an annuity offers no flexibility. Once you begin receiving payments, you cannot access a large sum if an emergency arises. You cannot change your mind and ask for your money back. This is the price of the insurance company's may provide.

An annuity is most useful when you have a large sum of money, want to convert it into predictable monthly income, and do not expect to need access to the principal. It works less well if you might need flexibility, want your money to grow, or want to leave a large inheritance.

Frequently Asked Questions

Can I change my mind after I buy a life insurance annuity?

Most annuities have a surrender period, usually 7 to 10 years, during which you can withdraw your money but will pay a penalty — often 5 to 10 percent of the amount withdrawn. After the surrender period ends, you can usually withdraw without penalty, but once you have started receiving monthly payments, you cannot stop them and get a lump sum back. Check your contract for the exact terms.

What if I die shortly after buying the annuity?

If you bought a basic life insurance annuity with no survivor benefits, the insurance company keeps the remaining balance and your beneficiary receives nothing. This is why many people choose a joint and survivor option or a period-certain may provide — they cost more but may support your heirs receive something if you die soon after purchase.

How does inflation affect my annuity payments?

A standard life insurance annuity pays the same amount every month for life, so inflation reduces what that money can buy over time. Some annuities offer a cost-of-living adjustment that increases your payment each year, but this feature reduces your starting payment. Without it, a $2,000 monthly payment may feel much smaller in 20 years.

Is a life insurance annuity the same as a fixed annuity?

A life insurance annuity is a type of fixed annuity — it pays a fixed amount each month. However, not all fixed annuities are life insurance annuities. Some fixed annuities pay for a set number of years rather than for life. Check whether the contract says payments continue for your lifetime or for a specific period.