How Does a Lifetime Annuity Work: Payments, Taxes, and Death Benefits

A lifetime annuity works as a trade: you hand an insurance company a sum of money, and the insurer commits to sending you income payments for as long as you live. The insurer takes on the risk that you outlive your savings, and in exchange it uses actuarial formulas to set a payment size that reflects your age, the amount you invested, and the contract features you chose. Federal tax rules under Internal Revenue Code Section 72 then determine how much of each payment stays in your pocket.¹

How the Money Goes In

You fund a lifetime annuity as either immediate or deferred. An immediate annuity takes a single lump-sum premium, and the insurer starts sending you income within a month to a year. A deferred annuity has an accumulation phase first, where your money grows before payments begin, sometimes decades later. Deferred contracts accept either a single premium or flexible contributions over time.

The entry point depends on the structure. Immediate annuities generally require $50,000 to $100,000 up front because they’re funded all at once. Deferred contracts often start lower since you can build the balance gradually. Once the accumulation phase ends, the contract locks in your benefit terms and moves to the payout stage.

Fixed and Variable Payments

A fixed lifetime annuity guarantees the same dollar amount with every payment. The insurer invests your premium conservatively and absorbs the market risk, so your income stays predictable. This is the common structure for people who want certainty in a retirement budget.

A variable lifetime annuity ties your payments to investment options you select, often stock and bond funds. Your check rises when those investments gain value and shrinks when they lose. Variable contracts offer more growth potential, carry more risk, and usually charge higher fees than fixed contracts.

How the Insurer Sets Your Payment

Insurance companies use actuarial formulas built around a handful of inputs. The biggest one is your age when payments begin, because that determines how long the insurer expects to pay you. A 70-year-old starting income will receive a larger check than a 60-year-old who invested the same amount, simply because the expected payout period is shorter.

Gender matters too. Women statistically live longer than men, so the insurer anticipates more payments to a female annuitant and adjusts each one downward. A larger premium buys larger payments because the insurer has more capital to distribute. Interest rates on the day you buy also feed in: when rates are higher, the insurer earns more on its reserves and passes some of that along.

Behind all of this sit mortality tables like the Commissioner’s Standard Ordinary Mortality Table, which give the insurer a statistical estimate of how long you’re likely to live. The insurer’s own financial strength matters as well. Independent rating agencies like AM Best assign letter grades from A++ down to D based on a company’s ability to meet its long-term contract obligations, and you should check that grade before you sign anything the rest of your life depends on.

Choosing How Payments Are Structured

Before income begins, you pick a payout option that decides how long the checks continue and who else, if anyone, receives them. This choice is permanent once payments start, so it carries more weight than almost any other decision in the process.

Single life only pays the largest check because the insurer’s obligation ends the moment you die. Nothing goes to a beneficiary.
Joint and survivor keeps payments going to a second person, usually a spouse, after you die. Because the insurer may be covering two lifetimes, each check is smaller.
Life with period certain pays for life, but if you die inside a guaranteed window (commonly 10 or 20 years), your beneficiary collects the rest of the payments through the end of that period. The added protection lowers each check compared to single life.

You also pick a payment frequency: monthly, quarterly, semi-annual, or annual. Monthly is the most common because it fits household budgeting. Funds arrive by direct deposit or mailed check, and the insurer is contractually bound to keep paying even after the total paid exceeds what you originally invested.

Adding an Inflation Adjustment

A fixed payment that feels comfortable at 65 can lose real buying power by 85. Many insurers offer a cost-of-living adjustment rider that raises your payment by a set percentage each year, typically 1% to 5%. You pick the rate at purchase, and it can’t be changed later.

The trade-off is direct: the higher the annual increase, the smaller your starting payment. The insurer trims your first check to fund the raises that follow, so it can take several years before the adjusted payment surpasses what a flat option would have paid. No commercial annuity tracks inflation in real time the way Social Security does; the fixed-percentage rider is an approximation, not a guarantee that your income will keep pace with actual prices.

What You Owe in Tax

How you funded the contract decides how much of each payment is taxable. The IRS draws a sharp line between qualified and non-qualified annuities.

Qualified Annuities

A qualified annuity sits inside a tax-advantaged account like a traditional IRA or 401(k). You contributed pre-tax dollars and never paid income tax on them going in, so every dollar coming out is taxed as ordinary income at your federal rate for that year.¹ Qualified annuities are also subject to required minimum distributions once you reach the RMD age (73 in 2026, rising to 75 in 2033 under the SECURE 2.0 Act). If your annuity is already in payout mode and the payments meet the minimum, you generally don’t have to withdraw anything extra.²

Non-Qualified Annuities and the Exclusion Ratio

A non-qualified annuity is bought with after-tax money. Taxing the whole payment again would double-tax your original contribution, so the IRS uses an exclusion ratio that splits each check into two parts: a tax-free return of your investment and a taxable portion representing earnings.¹

The formula divides your total investment by the expected return, meaning the total the insurer expects to pay you over your lifetime. Invest $100,000 with an expected return of $200,000 and the ratio is 50%: half of each check comes back tax-free, half is taxed as ordinary income.³ The ratio holds until you’ve recovered your full original investment. If you outlive the life expectancy used at the start of the contract, later payments become fully taxable because you’ve already received your after-tax contributions back.¹

Pulling Money Out Early

Taking cash out of a lifetime annuity before the contract allows can trigger two separate penalties: one from the insurer and one from the IRS.

Most deferred annuities carry a surrender charge if you withdraw more than a set amount during the early years. A typical schedule runs six to ten years, starting near 8% of the withdrawn amount in year one and declining by about a percentage point each year until it hits zero. Many contracts still let you take up to 10% of the account value annually without a surrender charge, even inside the surrender period.

The IRS adds a 10% additional tax on taxable withdrawals before age 59½. For non-qualified annuities, that penalty comes from Section 72(q) and applies only to the taxable portion of the withdrawal, not the return of your original investment. For qualified annuities in retirement accounts, the parallel penalty sits in Section 72(t).¹⁴

Both provisions carry exceptions. The penalty does not apply after death or disability, or when you set up a series of substantially equal periodic payments spread over your life expectancy. The 72(q) penalty also does not apply to immediate annuities, since those contracts exist to start paying right away.¹

What Happens When You Die

Death has different consequences depending on whether the contract is still accumulating or already paying out.

If you die in the accumulation phase, before payments have started, your beneficiary typically receives a death benefit equal to the account value or the total premiums paid, whichever is greater. Your heirs don’t lose the money you put in.

If you die in the payout phase, the outcome tracks the payout option you selected. Single life only stops payments immediately, and nothing passes to heirs. Joint and survivor keeps checks going to the surviving person. Life with period certain sends the remaining scheduled payments to your beneficiary if you die inside the guaranteed window.

For tax purposes, a beneficiary generally reports the income the same way you would have. On a non-qualified contract, a lump-sum death benefit is taxable only to the extent it exceeds the unrecovered cost of the contract, so your heirs aren’t taxed on the return of your original after-tax investment; ongoing payments follow the same exclusion ratio rules that applied to you. For qualified contracts, a surviving spouse may be able to roll the inherited annuity into their own IRA, and a non-spouse beneficiary can execute a direct trustee-to-trustee transfer into an inherited IRA to preserve the tax-deferred status.⁵

If the Insurer Fails

A lifetime annuity depends on the insurance company staying solvent for decades. Every state operates a guaranty association that steps in if your insurer fails, funded by assessments on other insurers licensed in that state, and it will continue your coverage up to a statutory limit.

The common protection level for annuities is $250,000 per person per insurer, which applies in most states. Several states set the limit at $300,000, and a handful — including Connecticut, New York, and Washington — cover up to $500,000. Some states also treat deferred and payout-stage annuities differently, extending higher coverage once payments have begun.⁶

If you plan to invest more than your state’s cap, one common approach is to split the money across annuities from two or more unrelated insurers so each contract qualifies for its own limit. Confirming both the insurer’s financial strength rating and your state’s specific coverage amount before you sign protects the contract from the one risk it can’t hedge on its own.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
3
Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
4
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
5
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
6
NOLHGA. How You’re Protected