What is an Annuity?
An annuity is a long-term financial planning tool. When applied to a life insurance policy payout, it is used to distribute the policy’s death benefit to the beneficiaries over time, rather than giving them a large lump sum of money at once.
Understanding annuities in general
Annuities are a type of product sold by insurance companies. You can apply them to a life insurance policy, which we’ll explore in a moment, but you can also purchase annuities for your own benefit.
When you choose the latter, you pay for the annuity just like you would any other insurance policy: by paying premiums to the insurance provider.
In return, the annuity provider gives you a set sum of money on a regular schedule. Your annuity can start right away, but most people defer these disbursements until retirement. At that point, the annuity provides a steady stream of income for them. During the premium payment years, the principal will grow both by adding premiums and based on other factors such as indexes, market interest rates, or mutual funds.
This all assumes that you buy an annuity as a financial planning tool for yourself. But you also have the option to choose a life insurance annuity, making this a financial planning tool for your beneficiaries.
Annuities and life insurance
Most life insurance policies pay out the death benefit as a lump sum. That means that when the insured passes away, their beneficiaries get all of the money from the life insurance policy right away.
But that can make financial planning a challenge. To ensure that the money provides for them for a longer period of time, they may choose to annuitize.
In this case, the life insurance provider holds the death benefit in an account and distributes a set amount of it to the beneficiary on a predetermined schedule. With a life insurance annuity, the beneficiary essentially gets another income stream over the years (e.g., 10 years, 20 years).
The money that remains in the account with the life insurance provider will earn interest at a fixed rate, but those earnings may be taxable.