If an immediate annuity is purchased with the face amount of a life insurance policy, the death benefit is converted into a stream of regular income payments instead of being received as a single lump sum. This is one of the standard settlement options available to beneficiaries when they file a death benefit claim, and it can also happen through a 1035 exchange by the policyholder during their lifetime. The choice affects how the money is taxed, how long it lasts, and whether any portion passes to heirs.
How the Face Amount Becomes an Annuity
When a life insurance policyholder dies, the beneficiary files a claim and chooses how to receive the death benefit. Most people take a lump sum, but many insurers offer the option to convert the face amount directly into an immediate annuity. If you choose this route, the insurance company keeps the proceeds and begins sending you periodic payments, typically monthly, starting within 30 days.
If the insurer doesn’t offer an annuity settlement option, you can take the lump sum and use it to purchase an immediate annuity from any carrier on the open market. This adds one extra step but gives you the ability to shop around for the best payout rate rather than accepting whatever your insurer offers. Payout rates vary by company and are influenced by your age, gender, the payout structure you select, and the interest rate environment at the time of purchase.
Payout Options You Can Choose
The face amount funds a single premium, meaning you pay once and income begins immediately. But you still need to decide how that income is structured. The main options are:
- Life only: Payments continue for as long as you live, no matter how long that is. This option produces the highest monthly payment because the insurer stops paying at your death, with nothing left for heirs. It works well if maximizing income is your priority and you have no dependents relying on the money.
- Joint and survivor: Payments continue for your lifetime and then for your spouse’s or partner’s lifetime. Because the insurer is covering two lives, each payment is smaller than a life-only annuity funded with the same face amount.
- Life with period certain: You receive payments for life, but if you die within a guaranteed period (commonly 10 or 20 years), your beneficiary continues receiving payments for the remainder of that period. This adds a safety net so the face amount isn’t lost if you die shortly after purchasing the annuity.
- Period certain only: Payments are guaranteed for a fixed number of years regardless of whether you’re alive. If you die during that window, your beneficiary receives the remaining payments. Once the period ends, payments stop even if you’re still living.
The choice between these structures is a tradeoff between payment size and protection. Life-only pays the most per month but carries the risk that a short lifespan means most of the face amount is forfeited. Period-certain options protect against that scenario but reduce each payment.
How Annuity Payments Are Taxed
Life insurance death benefits are generally received income-tax-free. That matters here because the face amount you use to buy the annuity becomes your “cost basis,” the portion of each payment the IRS considers a return of your own money rather than taxable income.
The IRS uses an exclusion ratio to split each annuity payment into two parts: a nontaxable return of principal and a taxable portion representing interest earned on the invested premium. For example, if $200,000 in death benefit proceeds funds an annuity expected to pay $300,000 over your lifetime, roughly two-thirds of each payment is treated as a tax-free return of principal and the remaining third is taxed as ordinary income. This formula slightly understates taxable income in the early years and overstates it in later years, but it’s the standard IRS method.
Once you’ve recovered your entire cost basis through those nontaxable portions, every dollar of every subsequent payment becomes fully taxable. If you live well beyond your life expectancy, you’ll eventually cross that threshold.
One important rule applies if the annuitant hasn’t yet reached age 59½: any distribution that counts as taxable income may also trigger a 10% early withdrawal penalty on top of regular income tax. This is worth considering when a younger beneficiary is deciding whether an annuity is the right settlement option.
What Happens with a 1035 Exchange
A living policyholder can also convert a life insurance policy’s cash value into an annuity through a 1035 exchange, named after the tax code section that governs it. This is a different situation from a beneficiary using the death benefit, but the phrase “purchased with the face amount” sometimes refers to it. In a 1035 exchange, you’re giving up the death benefit in exchange for a stream of income payments. No taxes are owed at the time of conversion, but a portion of each annuity payment will be taxable to reflect any gains above the premiums you originally paid into the policy.
Before going this route, consider whether your survivors will need the death benefit. Once you exchange the policy, there is no death benefit left. The annuity payments are for your benefit during your lifetime (or a specified period), and only certain payout structures pass remaining value to heirs.
Benefits of Converting the Face Amount
The primary advantage is income security. A large lump sum can be spent down quickly or invested poorly. An immediate annuity eliminates that risk by turning the face amount into predictable, guaranteed payments. For a beneficiary who depends on the deceased’s income, this can replicate something close to a regular paycheck.
There’s also a simplicity benefit. You don’t need to manage investments, rebalance a portfolio, or decide how much to withdraw each year. The insurance company handles the math and sends you a check.
Drawbacks to Consider
The biggest downside is loss of liquidity. Once the face amount is converted into an immediate annuity, you typically cannot access the remaining principal as a lump sum. If an emergency arises or you need a large amount of cash, you’re locked in to the payment schedule.
Inflation is another concern. Most immediate annuities pay a fixed dollar amount. A payment that feels comfortable today may lose purchasing power over 20 or 30 years. Some insurers offer inflation-adjusted annuities, but the starting payment is lower to account for future increases.
Finally, if you choose a life-only structure and die early, the insurance company keeps the remaining value. A $500,000 face amount that funds a life-only annuity could pay out only a fraction of that total if the annuitant dies within a few years. Period-certain options reduce this risk but cost you in lower monthly payments.
Shopping for the Best Rate
If you take the death benefit as a lump sum first, you can compare quotes from multiple annuity providers before committing. Payout rates vary meaningfully between companies, and a difference of even a fraction of a percentage point compounds into thousands of dollars over a lifetime of payments. Factors that affect your rate include your age at purchase, the payout option you select, the premium amount, and prevailing interest rates at the time the policy is issued. Getting quotes from at least three or four carriers gives you a realistic sense of the range available.