Tony Anderson / Getty Images If you’ve recently lost a loved one, you may not feel prepared to make big financial decisions, but it’s important to understand the tradeoffs and advantages of choosing income (via a life insurance annuity) over a lump sum.
What Is a Life Insurance Annuity?
A life insurance annuity is a method of paying out a death benefit over time. Instead of paying out the entire amount in a single (often substantial) lump sum, the life insurance company can set up a stream of payments. The payout schedule can be linked to a beneficiary’s life expectancy or a specified amount of time, or the number of payments can be determined according to both. Life insurance policies often have several payment options, also known as settlement options. Receiving a significant amount of money can be overwhelming and problematic; you might end up with more money than you’ve ever imagined and be unprepared to manage the funds. With installment payments via a life insurance annuity, you can improve the chances of making that money last over the long term.
How Does a Life Insurance Annuity Work?
Annuity payments can replace income or resources after someone’s death. Most people are accustomed to receiving monthly payments in the form of income, so annuity payments can make it easy for you to budget and manage month-to-month spending. When you take income from a death benefit, you might have several income choices available.
Lifetime Income
With this option, you receive income for the rest of your life expectancy. Payments stop after your death, whether that’s in the near or distant future.
Life With Period Certain
Payments continue for the longer of a period you choose (20 years, for example) or your life. This option may alleviate concerns about dying shortly after starting annuity payments, but still provide lifetime income. If you die before the period expires, remaining payments go to a beneficiary you choose.
Period Certain
With this option, you select a specific number of years to receive payments. If you die during the period, payments continue to a beneficiary you choose and stop at the end of it.
Fixed Amount
You choose an amount to receive based on your current needs. Payments continue until you use all of the funds available to you. If funds remain upon your death, a beneficiary can receive payments until the funds are exhausted.
Joint and Survivor
This payout option is tied to two lives, typically yours and a spouse. It guarantees the payments will continue for the duration of both. Depending on the insurance policy, you may have other options available as well. Carefully weigh your options, as different periods will pay out different amounts. The highest payment isn’t necessarily the best.
Tax and Interest on Annuity Payments
Income you receive from a life insurance annuity may be taxable—at least partially. In most cases, when you take the death benefit as a lump sum, you don’t owe taxes. But when you leave funds with the insurance company, you typically earn interest on that money. Each payment you receive may include a portion of the death benefit and a portion of interest earnings; the interest portion is generally taxable. Check with your tax preparer before you specify how you’d like to claim benefits from a life insurance policy. You need to know what (if anything) you’ll owe the IRS.
Pros and Cons of a Life Insurance Annuity
The decision to take income or a lump sum may be complicated, so take some time to carefully evaluate your needs.
Pros Explained
Replace Income
When the money is replacing income from a spouse, partner, or parent, annuity payments may be a natural fit since they look and feel like earnings from a job. As a result, the annuity option can simplify your finances during a difficult time.
Prevent Overspending
Having a substantial amount of money after the death of a loved one can be dizzying. While it may appear that you have robust resources, the money can go fast. It’s easy to overspend with a large account balance, but a steady income via annuity payments can ensure that money lasts longer.
Reduce Investment Mistakes
When you suddenly inherit a substantial amount, you may be a target for con artists (and you may be vulnerable after an emotional event). You might also be lured to invest in less-than-ideal ways that lead to tragic losses. Annuity payments might not be the perfect solution, but they’re relatively safe.
Protection From Creditors
If you have debt collectors seeking payments or a judgment entered against you, those creditors can only access the amount you’re periodically paid as opposed to the entire lump sum.
Cons Explained
May Be Harder To Pay Final Expenses
If you have substantial medical or final expenses, a lump-sum payout makes it easier to cover those costs.
No Lump Sum for Debts
If you take a death benefit as a lump sum, you can pay off large loans like a mortgage or high-interest debts. But if you choose annuity payments, you’ll need to keep making monthly payments (which, depending on the interest rate and other factors, might be fine).
Lack of Control and Access
Once you make the decision to receive annuity payments over a lump sum, it’s generally irrevocable, although some buyout options may exist. But there’s a cost, and these may only be worth it in dire circumstances.
No Lump Sum for Investments
Some beneficiaries would be better served by investing a lump sum instead of exchanging it for income. For example, you might prefer to fund tax-deferred accounts or pursue long-term growth with a lump-sum death benefit on which the earnings have more time to compound.
Potential Estate Implications
The proceeds from an annuity can contribute to the value of your taxable estate if you were the owner of the policy or if you transferred it to an irrevocable trust. This can change the value of your estate and impact its tax status.
