What Is a Guaranteed Lifetime Income Annuity? Payouts and Taxes

A guaranteed lifetime income annuity is a contract with an insurance company that turns a sum of money into regular payments you receive for the rest of your life, however long that turns out to be. The insurer absorbs two risks you’d otherwise carry alone: that your investments underperform, and that you outlive your savings. In return, you give up flexible access to the money you hand over, and once payments begin, the arrangement is generally locked in.

The Two Phases: Accumulation and Payout

Every contract has a phase where money goes in and a phase where money comes out. You fund the contract in one of two ways. A single premium annuity takes a lump sum, often rolled over from a retirement account or the sale of a home. A flexible premium annuity accepts smaller contributions over time before you start drawing income.

During accumulation, your deposits earn interest at rates spelled out in the contract, either fixed or tied to an index. Growth is tax-deferred, so you don’t owe income tax on the earnings until money comes out.¹ The insurer tracks your contract value as premiums paid, plus credited interest, minus fees. With variable annuities those fees commonly include a mortality and expense charge, often around 0.5 to 1.5 percent of account value per year. Fixed annuities usually build costs into the spread between what the insurer earns on its investments and the rate it credits to you, so you may not see an itemized charge, but the cost is still there. Insurers must disclose all charges at or before the time you apply.²

How the Lifetime Payment Is Calculated

When you’re ready to convert your balance into income, the insurer runs a calculation called annuitization. Two factors set the size of the check: how long the company expects to pay you, and prevailing interest rates.

For longevity, insurers use annuity-specific mortality tables. The standard for individual contracts is the 2012 Individual Annuity Reserving (IAR) Mortality Table, which the NAIC requires for determining reserve liabilities on new contracts.³ Annuity tables assume longer lifespans than life insurance tables because the financial risk runs the other way: an insurer loses money on an annuity when you live longer than expected, and loses money on life insurance when you die sooner.

Interest rates matter just as much. Higher rates let the insurer earn more on the reserves backing your payments, so it can offer a larger monthly amount. People who locked in payments during the low-rate years of 2020 and 2021 generally received smaller monthly checks than those who annuitized after rates rose. Once your payment is set, it usually cannot be changed. Timing is part of the deal.

Payout Options and What Each One Costs You

The option you pick determines both your monthly amount and what, if anything, is left for your family. The more protection you build in for others, the smaller the check.

Life only. The insurer pays the highest possible amount because its obligation ends the day you die. If you pass six months in, the company keeps the rest. Best fit for people without dependents who want maximum cash flow.
Joint and survivor. Payments continue to a surviving spouse or partner, typically at 50 to 100 percent of the original amount depending on the option you select. The starting payment is lower to fund two lifetimes.
Period certain. Payments are guaranteed for a set number of years, commonly 10 or 20, even if you die during that window. Die in year three of a 20-year guarantee, and your beneficiary receives the remaining 17 years. Often combined with a life option so payments continue for your lifetime or the guaranteed period, whichever is longer.
Return of premium rider. If you die before the insurer has paid out an amount equal to your original deposit, your beneficiaries receive the difference. You pay for this through a lower monthly payment or an explicit rider fee.

How the Income Is Taxed

Tax treatment depends almost entirely on where the money came from before it went into the contract.

Qualified Annuities

If you bought the annuity inside a traditional IRA, 401(k), or similar retirement account using money that was never taxed, every dollar coming out is taxed as ordinary income.⁴ There’s no tax-free portion, because you never paid tax on the way in. Required minimum distribution rules also apply. You generally must start withdrawals by April 1 of the year after you turn 73.⁵ Once you’ve annuitized, those lifetime payments typically satisfy the RMD for the annuitized portion, but any other IRA balances still need separate RMDs.

Non-Qualified Annuities

If you bought the contract with money from a regular savings or brokerage account, you’ve already paid tax on the principal. Each payment splits into a taxable earnings portion and a tax-free return of your original investment. The IRS calls the formula the exclusion ratio: divide your investment in the contract by the total expected return, and that percentage of each payment comes to you tax-free.¹⁶ Once you’ve recovered your full investment, every later payment is fully taxable.

The Early Withdrawal Penalty

Pulling money from any annuity before age 59½ generally adds a 10 percent penalty on top of regular income tax on the taxable portion.¹ Narrow exceptions exist for death, disability, and a few other situations. This is one of the strongest reasons to treat an annuity as a long-term commitment rather than a place to park money you might need soon.

What Access to Your Money Looks Like

This is where most buyer’s remorse happens. During the surrender period, often seven to ten years, the insurer charges a penalty if you withdraw more than a small allowed amount. A typical schedule starts around 7 to 9 percent of the withdrawn amount in year one and drops by roughly a percentage point each year until it reaches zero. Most contracts let you take out about 10 percent of the account value per year without triggering the charge.

Some contracts also include a market value adjustment, which can raise or lower your payout on an early surrender depending on how interest rates have moved since you bought.⁷ If rates have risen, the adjustment typically works against you. If rates have fallen, it can work in your favor. Your true cash-out value during the surrender period is uncertain until the moment you ask for it.

Once you annuitize and start receiving lifetime payments, the contract is generally irrevocable. You can’t go back and ask for the lump sum. The insurer has pooled your money with thousands of other contract holders to fund the payment stream, and there’s no unwinding that. Plan your liquidity before you sign.

Inflation Eats a Fixed Payment

A monthly amount that feels comfortable today buys less a decade from now, and considerably less two decades on. At 3 percent annual inflation, a $2,000 monthly payment has the purchasing power of roughly $1,100 after 20 years. For someone annuitizing at 65 and living to 90, that erosion is substantial.

Some insurers offer a cost-of-living adjustment rider that raises your payments each year, usually tied to the Consumer Price Index or a fixed 2 or 3 percent step-up. Your starting payment is noticeably lower under that structure, because the insurer has to fund the future increases. Whether it pays off depends on how long you live and how hot inflation runs.

The Guarantee Is Only as Strong as the Insurer

Unlike bank deposits, annuity guarantees are not federally insured. The promise depends on the insurer’s ability to pay claims decades from now, which makes checking the company far more important than it is for a certificate of deposit.

Independent rating agencies evaluate each insurer’s financial strength. AM Best, the most widely used for insurance, assigns a Financial Strength Rating reflecting its opinion of the insurer’s ability to meet ongoing contract obligations.⁸ The scale runs from A++ (Superior) down through A+/A (Excellent), B++/B+ (Good), and lower. Sticking with carriers rated A or higher eliminates most solvency risk. S&P and Moody’s also rate insurers, and checking at least two agencies gives a fuller picture.

State insurance departments regulate insurer solvency by monitoring reserve levels, conducting financial examinations, and requiring companies to hold enough assets to cover their obligations.⁹ When examiners find a company impaired, the state insurance department steps in and takes control.¹⁰

If an insurer actually fails, every state has a guaranty association that acts as a backstop. Limits vary by state and benefit type, but for annuities the protected amount is commonly $250,000 per contract owner. You can look up your state’s specific limit through the National Organization of Life and Health Insurance Guaranty Associations. This safety net helps, but it isn’t a substitute for a credit rating check. Claims on guaranty associations can take months or years to resolve.

Buying the Contract

Before an insurer issues a contract, a licensed agent or the company itself has to verify that the annuity is actually appropriate for you. Under the NAIC’s suitability standards, adopted in some form by every state, the agent must review your age, annual income, debts, existing assets, liquidity needs, risk tolerance, tax status, and intended use before making a recommendation.¹¹ If you’re replacing an existing annuity, the agent must also consider whether you’ll face surrender charges on the old contract and whether the new product genuinely benefits you.

Once the insurer approves the application and receives your funds, the policy is issued and a free look period begins. Under the NAIC’s model regulation, the minimum free look period is 15 days, though many states extend it to 20 or 30 days, particularly for buyers over age 60.² Use every day of it. Read the contract language on fees, the surrender schedule, the death benefit, and exactly how your payout is calculated. If anything doesn’t line up with what the agent described, this is your window to cancel and get a full refund. Once it closes, the surrender terms and everything else in the contract are yours to live with.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
National Association of Insurance Commissioners. Annuity Disclosure Model Regulation
3
National Association of Insurance Commissioners. Model Rule for Recognizing a New Annuity Mortality Table
4
Internal Revenue Service. Publication 590-B, Distributions from Individual Retirement Arrangements
5
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
6
Internal Revenue Service. Publication 939, General Rule for Pensions and Annuities
7
Insurance Compact. Additional Standards for Market Value Adjustment Feature Provided Through the General Account
8
AM Best. Guide to Best’s Credit Ratings – Financial Strength Rating Scale
9
U.S. Department of the Treasury. How To Modernize and Improve the System of Insurance Regulation in the United States
10
National Association of Insurance Commissioners. State Insurance Regulation
11
National Association of Insurance Commissioners. Suitability in Annuity Transactions Model Regulation