How Does a Lifetime Annuity Work? Payouts, Taxes, Withdrawals

A lifetime annuity works by converting a sum of money into guaranteed income payments that keep arriving for as long as you live. You pay an insurance company a premium, either in a single lump sum or over time, and in exchange the insurer commits to sending you a check on a set schedule until you die. The insurer takes on the risk that you outlive your savings; you take on the risk that you don’t live long enough to collect back everything you put in. How much each payment is worth depends on your age, the size of your premium, and the payout structure you select, and how much of that payment you keep depends on how the annuity was funded under Internal Revenue Code Section 72.

How the Contract Is Funded and When Payments Start

There are two basic structures. With an immediate annuity, you make one lump-sum payment and the insurer begins sending income within a month to a year. With a deferred annuity, there’s an accumulation phase first — your money grows inside the contract, sometimes for decades, before payments begin. Deferred contracts can be funded all at once or with flexible contributions over time.

Entry points differ by type. Immediate annuities, because they’re funded in one shot, usually require $50,000 to $100,000 up front. Deferred contracts often open at lower amounts since the balance is built gradually. Once the accumulation phase ends, the contract locks in your benefit terms and shifts into the payout stage.

Fixed or Variable Payments

A fixed lifetime annuity pays the same dollar amount every period. The insurer invests your premium conservatively and absorbs the investment risk, which is why the income stays predictable regardless of what markets do. It’s the common choice for people building a reliable retirement budget.

A variable lifetime annuity ties your payments to the performance of investment options you select, typically stock and bond funds. When those investments gain value, payments rise; when they lose value, payments shrink. Variable contracts offer more growth potential, carry more risk, and generally come with higher fees.

What Determines the Size of Each Payment

Insurance companies set payment amounts using actuarial formulas. Your age when payments begin is the biggest single factor because it drives 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 paid the same premium, because the expected payout period is shorter.

Gender matters because women statistically live longer than men, so the insurer anticipates making more payments to a female annuitant. A larger premium produces larger payments. Interest rates at the time you buy also move the number: when rates are higher, the insurer earns more on its reserves and can pass some of that through.

Insurers rely on mortality tables to estimate life expectancy, and those tables provide the statistical basis for how much can be paid per period while still covering obligations to every policyholder. The financial strength of the insurer is worth checking before you buy, since independent rating agencies like AM Best grade insurers on their long-term ability to meet contract obligations.

Choosing a Payout Option

Before income begins, you pick a payout structure that governs how long and to whom the insurer pays. This choice is permanent once payments start, which makes it one of the most consequential decisions in the process.

Single life only pays the highest per-check amount because the insurer’s obligation ends the moment you die. Nothing goes to a beneficiary.
Joint and survivor continues payments to a second person, usually a spouse, after you die. Each check is smaller because the insurer may be paying across two lifetimes.
Life with period certain pays you for life, but if you die within a guaranteed window (commonly 10 or 20 years), your beneficiary collects the remaining payments through the end of that period. The extra protection reduces each check compared with single-life.

You also pick a payment frequency. Monthly is the most common because it lines up with household budgeting, but quarterly, semi-annual, and annual options exist. The insurer pays by direct deposit or mailed check, and it stays contractually bound to continue paying even if the total paid out exceeds your original premium.

Adjusting for Inflation

A fixed payment that feels comfortable at 65 can lose real purchasing power by 85. Many insurers offer a cost-of-living adjustment rider that raises your payments by a set percentage, typically 1% to 5%, each year for the life of the contract. You pick the increase rate at purchase, and it cannot be changed afterward.

The trade-off is direct: the higher the annual increase, the smaller your starting payment. The insurer reduces your initial income to fund the future raises, so it can take several years before the inflation-adjusted stream passes what a flat-payment contract would have delivered. No commercial annuity tracks inflation in real time the way Social Security’s annual adjustment does; the fixed-percentage increase is an approximation.

How Your Payments Are Taxed

Taxation depends on how you funded the contract. The IRS draws a sharp line between qualified and non-qualified annuities.

Qualified Annuities

A qualified annuity sits inside a tax-advantaged retirement account like a traditional IRA or 401(k). Because you contributed pre-tax dollars, you never paid income tax on the money going in. Every dollar you receive during the payout phase is taxed as ordinary income at your federal rate for that year.¹

Non-Qualified Annuities and the Exclusion Ratio

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

The formula divides your total investment in the contract by the expected return, meaning the total the insurer expects to pay you over your lifetime. Invest $100,000 against a $200,000 expected return and the exclusion ratio is 50%: half of each check is tax-free, and you owe income tax only on the other half.²

The exclusion ratio applies until you’ve recovered your entire original investment. If you outlive the life expectancy used at the start of the contract, every payment after that point becomes fully taxable, because the after-tax portion has already been returned.¹

Required Distributions for Qualified Annuities

If your lifetime annuity sits inside a qualified retirement account, federal law requires you to start taking distributions by a certain age even if you don’t need the income. For 2026, that age is 73. The first required minimum distribution is due by April 1 of the year after you turn 73, and later ones are due by December 31 each year.³

Under the SECURE 2.0 Act, the RMD age rises to 75 starting in 2033. If your annuity is already in payout mode and the payments satisfy the minimum distribution rules, you generally won’t need to take additional withdrawals. Non-qualified annuities aren’t subject to RMD rules because they were funded with after-tax dollars outside a retirement account.

What It Costs to Take Money Out Early

Pulling money out before the contract allows can trigger two separate penalties, one from the insurance company and one from the IRS.

Insurance Company Surrender Charges

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

IRS Early Withdrawal Penalties

Taking taxable funds out of an annuity before age 59½ triggers a 10% additional tax on top of the regular income tax. For non-qualified annuities, this penalty comes from Section 72(q) and applies to the taxable portion of the withdrawal, not the return of your original investment.¹

For qualified annuities held inside retirement accounts, the parallel provision under Section 72(t) works the same way: a 10% additional tax on early distributions before age 59½.⁴

Both provisions have exceptions. The penalty doesn’t apply after death or disability, or where you set up a series of substantially equal periodic payments across your life expectancy. The 72(q) penalty also doesn’t apply to immediate annuities, since the whole point of those contracts is to begin paying out right away.¹

Switching Contracts Without Triggering Tax

If you own a lifetime annuity and want to move to a different annuity with better terms or lower fees, Section 1035 of the Internal Revenue Code lets you exchange one annuity contract for another without recognizing any gain.⁵

The exchange has to run directly between insurance companies; if you take possession of the money and redeposit it, the tax deferral is lost. The statute allows annuity-to-annuity exchanges and annuity-to-qualified-long-term-care exchanges, but not annuity-to-life-insurance. A 1035 exchange preserves your original cost basis, so the tax treatment of future payments stays the same as if you’d kept the original contract.⁵

What Your Heirs Receive When You Die

The outcome depends on whether the contract is still accumulating or already paying out.

If you die during the accumulation phase, before any payments have started, your beneficiary typically receives a death benefit equal to the account value or the total premiums you paid, whichever is greater. The money you put in doesn’t vanish.

If you die during the payout phase, the result depends entirely on the payout option you chose. Under single-life-only, payments stop and nothing passes to heirs. Under joint-and-survivor, the second person keeps collecting for life. Under life-with-period-certain, if you die inside the guaranteed window, your beneficiary receives the remaining payments through the end of that period.

Tax Treatment for Beneficiaries

A beneficiary generally reports income the same way the original owner would have. For a non-qualified annuity, 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. If the beneficiary takes ongoing payments instead, those follow the same exclusion ratio rules.⁶

For qualified annuities, a surviving spouse may be able to roll the inherited annuity into their own IRA. A non-spouse beneficiary can use a direct trustee-to-trustee transfer into an inherited IRA, keeping the tax-deferred status intact while meeting the required distribution timelines.⁶

If the Insurance Company Fails

Because a lifetime annuity depends on the insurer staying solvent for decades, every state runs a guaranty association that steps in if the company fails. These associations are funded by assessments on other insurers in the state and continue coverage up to a statutory limit.

The most 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, protect up to $500,000. Some states also distinguish between deferred annuities and those already in payout, offering higher coverage once payments have begun.⁷

If you plan to invest more than your state’s coverage limit, one common approach is to split the money across annuities from two or more unrelated insurers. Each contract qualifies for its own protection limit. Confirming your state’s specific coverage amount and checking the insurer’s financial strength rating adds a layer of security to a contract that may run the rest of your life.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
3
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
4
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
5
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
6
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
7
NOLHGA. How You’re Protected